Business Cycles: Recent Episodes
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Business Cycles includes theoretical works on business cycles, regularly occurring booms and busts. Not confined to Austrian business cycle theory (ABCT).
Study of business cycles must be based upon a satisfactory cycle theory. Gazing at sheaves of statistics without "pre-judgment" is futile. A cycle takes place in the economic world, and therefore a usable cycle theory must be integrated with general economic theory. And yet, remarkably, such integration, even attempted integration, is the exception, not the rule. Economics, in the last two decades, has fissured badly into a host of airtight compartments—each sphere hardly related to the others. Only in the theories of Schumpeter and Mises has cycle theory been integrated into general economics.Various neo-Keynesians have advanced cycle theories. They are integrated, however, not with general economic theory, but with holistic Keynesian systems—systems which are very partial indeed.
The bulk of cycle specialists, who spurn any systematic integration as impossibly deductive and overly simplified, are thereby (wittingly or unwittingly) rejecting economics itself. For if one may forge a theory of the cycle with little or no relation to general economics, then general economics must be incorrect, failing as it does to account for such a vital economic phenomenon. For institutionalists—the pure data collectors—if not for others, this is a welcome conclusion. Even institutionalists, however, must use theory sometimes, in analysis and recommendation; in fact, they end by using a concoction of ad hoc hunches, insights, etc., plucked unsystematically from various theoretical gardens. Few, if any, economists have realized that the Mises theory of the trade cycle is not just another theory: that, in fact, it meshes closely with a general theory of the economic system.There is, for example, not a hint of such knowledge in Haberler's well-known discussion. See Gottfried Haberler, Prosperity and Depression (2nd ed., Geneva, Switzerland: League of Nations, 1939). The Mises theory is, in fact, the economic analysis of the necessary consequences of intervention in the free market by bank credit expansion. Followers of the Misesian theory have often displayed excessive modesty in pressing its claims; they have widely protested that the theory is "only one of many possible explanations of business cycles," and that each cycle may fit a different causal theory. In this, as in so many other realms, eclecticism is misplaced. Since the Mises theory is the only one that stems from a general economic theory, it is the only one that can provide a correct explanation. Unless we are prepared to abandon general theory, we must reject all proposed explanations that do not mesh with general economics.
Business Cycles and Business Fluctuations It is important, first, to distinguish between business cycles and ordinary business fluctuations. We live necessarily in a society of continual and unending change, change that can never be precisely charted in advance. People try to forecast and anticipate changes as best they can, but such forecasting can never be reduced to an exact science. Entrepreneurs are in the business of forecasting changes on the market, both for conditions of demand and of supply. The more successful ones make profits pari passus with their accuracy of judgment, while the unsuccessful forecasters fall by the wayside. As a result, the successful entrepreneurs on the free market will be the ones most adept at anticipating future business conditions. Yet, the forecasting can never be perfect, and entrepreneurs will continue to differ in the success of their judgments. If this were not so, no profits or losses would ever be made in business.
Changes, then, take place continually in all spheres of the economy. Consumer tastes shift; time preferences and consequent proportions of investment and consumption change; the labor force changes in quantity, quality, and location; natural resources are discovered and others are used up; technological changes alter production possibilities; vagaries of climate alter crops, etc. All these changes are typical features of any economic system. In fact, we could not truly conceive of a changeless society, in which everyone did exactly the same things day after day, and no economic data ever changed. And even if we could conceive of such a society, it is doubtful whether many people would wish to bring it about.
It is, therefore, absurd to expect every business activity to be "stabilized" as if these changes were not taking place. To stabilize and "iron out" these fluctuations would, in effect, eradicate any rational productive activity. To take a simple, hypothetical case, suppose that a community is visited every seven years by the seven-year locust. Every seven years, therefore, many people launch preparations to deal with the locusts: produce anti-locust equipment, hire trained locust specialists, etc. Obviously, every seven years there is a "boom" in the locust-fighting industry, which, happily, is "depressed" the other six years. Would it help or harm matters if everyone decided to "stabilize" the locust-fighting industry by insisting on producing the machinery evenly every year, only to have it rust and become obsolete? Must people be forced to build machines before they want them; or to hire people before they are needed; or, conversely, to delay building machines they want—all in the name of "stabilization"? If people desire more autos and fewer houses than formerly, should they be forced to keep buying houses and be prevented from buying the autos, all for the sake of stabilization? As Dr. F.A. Harper has stated:
This sort of business fluctuation runs all through our daily lives. There is a violent fluctuation, for instance, in the harvest of strawberries at different times during the year. Should we grow enough strawberries in greenhouses so as to stabilize that part of our economy throughout the year.F.A. Harper, Why Wages Rise (Irvington-on-Hudson, N.Y.: Foundation for Economic Education, 1957), pp. 118–19.
We may, therefore, expect specific business fluctuations all the time. There is no need for any special "cycle theory" to account for them. They are simply the results of changes in economic data and are fully explained by economic theory. Many economists, however, attribute general business depression to "weaknesses" caused by a "depression in building" or a "farm depression." But declines in specific industries can never ignite a general depression. Shifts in data will cause increases in activity in one field, declines in another. There is nothing here to account for a general business depression—a phenomenon of the true "business cycle." Suppose, for example, that a shift in consumer tastes, and technologies, causes a shift in demand from farm products to other goods. It is pointless to say, as many people do, that a farm depression will ignite a general depression, because farmers will buy less goods, the people in industries selling to farmers will buy less, etc. This ignores the fact that people producing the other goods now favored by consumers will prosper; their demands will increase.
The problem of the business cycle is one of general boom and depression; it is not a problem of exploring specific industries and wondering what factors make each one of them relatively prosperous or depressed. Some economists—such as Warren and Pearson or Dewey and Dakin—have believed that there are no such things as general business fluctuations—that general movements are but the results of different cycles that take place, at different specific time-lengths, in the various economic activities. To the extent that such varying cycles (such as the 20-year "building cycle" or the seven-year locust cycle) may exist, however, they are irrelevant to a study of business cycles in general or to business depressions in particular. What we are trying to explain are general booms and busts in business.
In considering general movements in business, then, it is immediately evident that such movements must be transmitted through the general medium of exchange—money. Money forges the connecting link between all economic activities. If one price goes up and another down, we may conclude that demand has shifted from one industry to another; but if all prices move up or down together, some change must have occurred in the monetary sphere. Only changes in the demand for, and/or the supply of, money will cause general price changes. An increase in the supply of money, the demand for money remaining the same, will cause a fall in the purchasing power of each dollar, i.e., a general rise in prices; conversely, a drop in the money supply will cause a general decline in prices. On the other hand, an increase in the general demand for money, the supply remaining given, will bring about a rise in the purchasing power of the dollar (a general fall in prices); while a fall in demand will lead to a general rise in prices. Changes in prices in general, then, are determined by changes in the supply of and demand for money. The supply of money consists of the stock of money existing in the society. The demand for money is, in the final analysis, the willingness of people to hold cash balances, and this can be expressed as eagerness to acquire money in exchange, and as eagerness to retain money in cash balance. The supply of goods in the economy is one component in the social demand for money; an increased supply of goods will, other things being equal, increase the demand for money and therefore tend to lower prices. Demand for money will tend to be lower when the purchasing power of the money-unit is higher, for then each dollar is more effective in cash balance. Conversely, a lower purchasing power (higher prices) means that each dollar is less effective, and more dollars will be needed to carry on the same work.
The purchasing power of the dollar, then, will remain constant when the stock of, and demand for, money are in equilibrium with each other: i.e., when people are willing to hold in their cash balances the exact amount of money in existence. If the demand for money exceeds the stock, the purchasing power of money will rise until the demand is no longer excessive and the market is cleared; conversely, a demand lower than supply will lower the purchasing power of the dollar, i.e., raise prices.
Yet, fluctuations in general business, in the "money relation," do not by themselves provide the clue to the mysterious business cycle. It is true that any cycle in general business must be transmitted through this money relation: the relation between the stock of, and the demand for, money. But these changes in themselves explain little. If the money supply increases or demand falls, for example, prices will rise; but why should this generate a "business cycle"? Specifically, why should it bring about a depression? The early business cycle theorists were correct in focusing their attention on the crisis and depression: for these are the phases that puzzle and shock economists and laymen alike, and these are the phases that most need to be explained.
The Problem: The Cluster of Error The explanation of depressions, then, will not be found by referring to specific or even general business fluctuations per se. The main problem that a theory of depression must explain is: why is there a sudden general cluster of business errors? This is the first question for any cycle theory. Business activity moves along nicely with most business firms making handsome profits. Suddenly, without warning, conditions change and the bulk of business firms are experiencing losses; they are suddenly revealed to have made grievous errors in forecasting.
A general review of entrepreneurship is now in order. Entrepreneurs are largely in the business of forecasting. They must invest and pay costs in the present, in the expectation of recouping a profit by sale either to consumers or to other entrepreneurs further down in the economy's structure of production. The better entrepreneurs, with better judgment in forecasting consumer or other producer demands, make profits; the inefficient entrepreneurs suffer losses. The market, therefore, provides a training ground for the reward and expansion of successful, far-sighted entrepreneurs and the weeding out of inefficient businessmen. As a rule only some businessmen suffer losses at any one time; the bulk either break even or earn profits. How, then, do we explain the curious phenomenon of the crisis when almost all entrepreneurs suffer sudden losses? In short, how did all the country's astute businessmen come to make such errors together, and why were they all suddenly revealed at this particular time? This is the great problem of cycle theory.
It is not legitimate to reply that sudden changes in the data are responsible. It is, after all, the business of entrepreneurs to forecast future changes, some of which are sudden. Why did their forecasts fail so abysmally?
Another common feature of the business cycle also calls for an explanation. It is the well-known fact that capital-goods industries fluctuate more widely than do the consumer-goods industries. The capital-goods industries—especially the industries supplying raw materials, construction, and equipment to other industries—expand much further in the boom, and are hit far more severely in the depression.
A third feature of every boom that needs explaining is the increase in the quantity of money in the economy. Conversely, there is generally, though not universally, a fall in the money supply during the depression.
The Explanation: Boom and Depression In the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time.Siegfried Budge, Grundzüge der Theoretische Nationalökonomie (Jena, 1925), quoted in Simon S. Kuznets, "Monetary Business Cycle Theory in Germany," Journal of Political Economy (April, 1930): 127–28."Under conditions of free competition . . . the market is . . . dependent upon supply and demand . . . there could [not] develop a disproportionality in the production of goods, which could draw in the whole economic system . . . such a disproportionality can arise only when, at some decisive point, the price structure does not base itself upon the play of only free competition, so that some arbitrary influence becomes possible."Kuznets himself criticizes the Austrian theory from his empiricist, anti-cause and effect-standpoint, and also erroneously considers this theory to be "static." The "boom-bust" cycle is generated by monetary intervention in the market, specifically bank credit expansion to business. Let us suppose an economy with a given supply of money. Some of the money is spent in consumption; the rest is saved and invested in a mighty structure of capital, in various orders of production. The proportion of consumption to saving or investment is determined by people's time preferences—the degree to which they prefer present to future satisfactions. The less they prefer them in the present, the lower will their time preference rate be, and the lower therefore will be the pure interest rate, which is determined by the time preferences of the individuals in society. A lower time-preference rate will be reflected in greater proportions of investment to consumption, a lengthening of the structure of production, and a building-up of capital. Higher time preferences, on the other hand, will be reflected in higher pure interest rates and a lower proportion of investment to consumption. The final market rates of interest reflect the pure interest rate plus or minus entrepreneurial risk and purchasing power components. Varying degrees of entrepreneurial risk bring about a structure of interest rates instead of a single uniform one, and purchasing-power components reflect changes in the purchasing power of the dollar, as well as in the specific position of an entrepreneur in relation to price changes. The crucial factor, however, is the pure interest rate. This interest rate first manifests itself in the "natural rate" or what is generally called the going "rate of profit." This going rate is reflected in the interest rate on the loan market, a rate which is determined by the going profit rate.This is the "pure time preference theory" of the rate of interest; it can be found in Ludwig von Mises, Human Action (New Haven, Conn.: Yale University Press, 1949); in Frank A. Fetter, Economic Principles (New York: Century, 1915), and idem, "Interest Theories Old and New," American Economic Review (March, 1914): 68–92.
Now what happens when banks print new money (whether as bank notes or bank deposits) and lend it to business?"Banks," for many purposes, include also savings and loan associations, and life insurance companies, both of which create new money via credit expansion to business. See below for further discussion of the money and banking question. The new money pours forth on the loan market and lowers the loan rate of interest. It looks as if the supply of saved funds for investment has increased, for the effect is the same: the supply of funds for investment apparently increases, and the interest rate is lowered. Businessmen, in short, are misled by the bank inflation into believing that the supply of saved funds is greater than it really is. Now, when saved funds increase, businessmen invest in "longer processes of production," i.e., the capital structure is lengthened, especially in the "higher orders" most remote from the consumer. Businessmen take their newly acquired funds and bid up the prices of capital and other producers' goods, and this stimulates a shift of investment from the "lower" (near the consumer) to the "higher" orders of production (furthest from the consumer)—from consumer goods to capital goods industries.On the structure of production, and its relation to investment and bank credit, see F.A. Hayek, Prices and Production (2nd ed., London: Routledge and Kegan Paul, 1935); Mises, Human Action; and Eugen von Böhm-Bawerk, "Positive Theory of Capital," in Capital and Interest (South Holland, Ill.: Libertarian Press, 1959), vol. 2.
If this were the effect of a genuine fall in time preferences and an increase in saving, all would be well and good, and the new lengthened structure of production could be indefinitely sustained. But this shift is the product of bank credit expansion. Soon the new money percolates downward from the business borrowers to the factors of production: in wages, rents, interest. Now, unless time preferences have changed, and there is no reason to think that they have, people will rush to spend the higher incomes in the old consumption-investment proportions. In short, people will rush to reestablish the old proportions, and demand will shift back from the higher to the lower orders. Capital goods industries will find that their investments have been in error: that what they thought profitable really fails for lack of demand by their entrepreneurial customers. Higher orders of production have turned out to be wasteful, and the malinvestment must be liquidated.
A favorite explanation of the crisis is that it stems from "underconsumption"—from a failure of consumer demand for goods at prices that could be profitable. But this runs contrary to the commonly known fact that it is capital goods, and not consumer goods, industries that really suffer in a depression. The failure is one of entrepreneurial demand for the higher order goods, and this in turn is caused by the shift of demand back to the old proportions.
In sum, businessmen were misled by bank credit inflation to invest too much in higher-order capital goods, which could only be prosperously sustained through lower time preferences and greater savings and investment; as soon as the inflation permeates to the mass of the people, the old consumption-investment proportion is reestablished, and business investments in the higher orders are seen to have been wasteful."Inflation" is here defined as an increase in the money supply not consisting of an increase in the money metal. Businessmen were led to this error by the credit expansion and its tampering with the free-market rate of interest.
The "boom," then, is actually a period of wasteful misinvestment. It is the time when errors are made, due to bank credit's tampering with the free market. The "crisis" arrives when the consumers come to reestablish their desired proportions. The "depression" is actually the process by which the economy adjusts to the wastes and errors of the boom, and reestablishes efficient service of consumer desires. The adjustment process consists in rapid liquidation of the wasteful investments. Some of these will be abandoned altogether (like the Western ghost towns constructed in the boom of 1816-1818 and deserted during the Panic of 1819); others will be shifted to other uses. Always the principle will be not to mourn past errors, but to make most efficient use of the existing stock of capital. In sum, the free market tends to satisfy voluntarily-expressed consumer desires with maximum efficiency, and this includes the public's relative desires for present and future consumption. The inflationary boom hobbles this efficiency, and distorts the structure of production, which no longer serves consumers properly. The crisis signals the end of this inflationary distortion, and the depression is the process by which the economy returns to the efficient service of consumers. In short, and this is a highly important point to grasp, the depression is the "recovery" process, and the end of the depression heralds the return to normal, and to optimum efficiency. The depression, then, far from being an evil scourge, is the necessary and beneficial return of the economy to normal after the distortions imposed by the boom. The boom, then, requires a "bust."
Since it clearly takes very little time for the new money to filter down from business to factors of production, why don't all booms come quickly to an end? The reason is that the banks come to the rescue. Seeing factors bid away from them by consumer goods industries, finding their costs rising and themselves short of funds, the borrowing firms turn once again to the banks. If the banks expand credit further, they can again keep the borrowers afloat. The new money again pours into business, and they can again bid factors away from the consumer goods industries. In short, continually expanded bank credit can keep the borrowers one step ahead of consumer retribution. For this, we have seen, is what the crisis and depression are: the restoration by consumers of an efficient economy, and the ending of the distortions of the boom. Clearly, the greater the credit expansion and the longer it lasts, the longer will the boom last. The boom will end when bank credit expansion finally stops. Evidently, the longer the boom goes on the more wasteful the errors committed, and the longer and more severe will be the necessary depression readjustment.
Thus, bank credit expansion sets into motion the business cycle in all its phases: the inflationary boom, marked by expansion of the money supply and by malinvestment; the crisis, which arrives when credit expansion ceases and malinvestments become evident; and the depression recovery, the necessary adjustment process by which the economy returns to the most efficient ways of satisfying consumer desires.This "Austrian" cycle theory settles the ancient economic controversy on whether or not changes in the quantity of money can affect the rate of interest. It supports the "modern" doctrine that an increase in the quantity of money lowers the rate of interest (if it first enters the loan market); on the other hand, it supports the classical view that, in the long run, quantity of money does not affect the interest rate (or can only do so if time preferences change). In fact, the depression-readjustment is the market's return to the desired free-market rate of interest.
What, specifically, are the essential features of the depression-recovery phase? Wasteful projects, as we have said, must either be abandoned or used as best they can be. Inefficient firms, buoyed up by the artificial boom, must be liquidated or have their debts scaled down or be turned over to their creditors. Prices of producers' goods must fall, particularly in the higher orders of production—this includes capital goods, lands, and wage rates. Just as the boom was marked by a fall in the rate of interest, i.e., of price differentials between stages of production (the "natural rate" or going rate of profit) as well as the loan rate, so the depression-recovery consists of a rise in this interest differential. In practice, this means a fall in the prices of the higher-order goods relative to prices in the consumer goods industries. Not only prices of particular machines must fall, but also the prices of whole aggregates of capital, e.g., stock market and real estate values. In fact, these values must fall more than the earnings from the assets, through reflecting the general rise in the rate of interest return.
Since factors must shift from the higher to the lower orders of production, there is inevitable "frictional" unemployment in a depression, but it need not be greater than unemployment attending any other large shift in production. In practice, unemployment will be aggravated by the numerous bankruptcies, and the large errors revealed, but it still need only be temporary. The speedier the adjustment, the more fleeting will the unemployment be. Unemployment will progress beyond the "frictional" stage and become really severe and lasting only if wage rates are kept artificially high and are prevented from falling. If wage rates are kept above the free-market level that clears the demand for and supply of labor, laborers will remain permanently unemployed. The greater the degree of discrepancy, the more severe will the unemployment be.
Secondary Features of Depression: Deflationary Credit Contraction The above are the essential features of a depression. Other secondary features may also develop. There is no need, for example, for deflation (lowering of the money supply) during a depression. The depression phase begins with the end of inflation, and can proceed without any further changes from the side of money. Deflation has almost always set in, however. In the first place, the inflation took place as an expansion of bank credit; now, the financial difficulties and bankruptcies among borrowers cause banks to pull in their horns and contract credit.It is often maintained that since business firms can find few profitable opportunities in a depression, business demand for loans falls off, and hence loans and money supply will contract. But this argument overlooks the fact that the banks, if they want to, can purchase securities, and thereby sustain the money supply by increasing their investments to compensate for dwindling loans. Contractionist pressure therefore always stems from banks and not from business borrowers. Under the gold standard, banks have another reason for contracting credit—if they had ended inflation because of a gold drain to foreign countries. The threat of this drain forces them to contract their outstanding loans. Furthermore the rash of business failures may cause questions to be raised about the banks; and banks, being inherently bankrupt anyway, can ill afford such questions.Banks are "inherently bankrupt" because they issue far more warehouse receipts to cash (nowadays in the form of "deposits" redeemable in cash on demand) than they have cash available. Hence, they are always vulnerable to bank runs. These runs are not like any other business failures, because they simply consist of depositors claiming their own rightful property, which the banks do not have. "Inherent bankruptcy," then, is an essential feature of any "fractional reserve" banking system. As Frank Graham stated:"The attempt of the banks to realize the inconsistent aims of lending cash, or merely multiplied claims to cash, and still to represent that cash is available on demand is even more preposterous than . . . eating one's cake and counting on it for future consumption. . . . The alleged convertibility is a delusion dependent upon the right's not being unduly exercised."Frank D. Graham, "Partial Reserve Money and the 100% Proposal," American Economic Review (September, 1936): 436. Hence, the money supply will contract because of actual bank runs, and because banks will tighten their position in fear of such runs.
Another common secondary feature of depressions is an increase in the demand for money. This "scramble for liquidity" is the result of several factors: (1) people expect falling prices, due to the depression and deflation, and will therefore hold more money and spend less on goods, awaiting the price fall; (2) borrowers will try to pay off their debts, now being called by banks and by business creditors, by liquidating other assets in exchange for money; (3) the rash of business losses and bankruptcies makes businessmen cautious about investing until the liquidation process is over.
With the supply of money falling, and the demand for money increasing, generally falling prices are a consequent feature of most depressions. A general price fall, however, is caused by the secondary, rather than by the inherent, features of depressions. Almost all economists, even those who see that the depression adjustment process should be permitted to function unhampered, take a very gloomy view of the secondary deflation and price fall, and assert that they unnecessarily aggravate the severity of depressions. This view, however, is incorrect. These processes not only do not aggravate the depression, they have positively beneficial effects.
There is, for example, no warrant whatever for the common hostility toward "hoarding." There is no criterion, first of all, to define "hoarding"; the charge inevitably boils down to mean that A thinks that B is keeping more cash balances than A deems appropriate for B. Certainly there is no objective criterion to decide when an increase in cash balance becomes a "hoard." Second, we have seen that the demand for money increases as a result of certain needs and values of the people; in a depression, fears of business liquidation and expectations of price declines particularly spur this rise. By what standards can these valuations be called "illegitimate"? A general price fall is the way that an increase in the demand for money can be satisfied; for lower prices mean that the same total cash balances have greater effectiveness, greater "real" command over goods and services. In short, the desire for increased real cash balances has now been satisfied.
Furthermore, the demand for money will decline again as soon as the liquidation and adjustment processes are finished. For the completion of liquidation removes the uncertainties of impending bankruptcy and ends the borrowers' scramble for cash. A rapid unhampered fall in prices, both in general (adjusting to the changed money-relation), and particularly in goods of higher orders (adjusting to the malinvestments of the boom) will speedily end the realignment processes and remove expectations of further declines. Thus, the sooner the various adjustments, primary and secondary, are carried out, the sooner will the demand for money fall once again. This, of course, is just one part of the general economic "return to normal."
Neither does the increased "hoarding" nor the fall of prices at all interfere with the primary depression-adjustment. The important feature of the primary adjustment is that the prices of producers' goods fall more rapidly than do consumer good prices (or, more accurately, that higher order prices fall more rapidly than do those of lower order goods); it does not interfere with the primary adjustment if all prices are falling to some degree. It is, moreover, a common myth among laymen and economists alike, that falling prices have a depressing effect on business. This is not necessarily true. What matters for business is not the general behavior of prices, but the price differentials between selling prices and costs (the "natural rate of interest"). If wage rates, for example, fall more rapidly than product prices, this stimulates business activity and employment.
Deflation of the money supply (via credit contraction) has fared as badly as hoarding in the eyes of economists. Even the Misesian theorists deplore deflation and have seen no benefits accruing from it.In a gold standard country (such as America during the 1929 depression), Austrian economists accepted credit contraction as a perhaps necessary price to pay for remaining on gold. But few saw any remedial virtues in the deflation process itself. Yet, deflationary credit contraction greatly helps to speed up the adjustment process, and hence the completion of business recovery, in ways as yet unrecognized. The adjustment consists, as we know, of a return to the desired consumption-saving pattern. Less adjustment is needed, however, if time preferences themselves change: i.e., if savings increase and consumption relatively declines. In short, what can help a depression is not more consumption, but, on the contrary, less consumption and more savings (and, concomitantly, more investment). Falling prices encourage greater savings and decreased consumption by fostering an accounting illusion. Business accounting records the value of assets at their original cost. It is well known that general price increases distort the accounting-record: what seems to be a large "profit" may only be just sufficient to replace the now higher-priced assets. During an inflation, therefore, business "profits" are greatly overstated, and consumption is greater than it would be if the accounting illusion were not operating—perhaps capital is even consumed without the individual's knowledge. In a time of deflation, the accounting illusion is reversed: what seem like losses and capital consumption, may actually mean profits for the firm, since assets now cost much less to be replaced. This overstatement of losses, however, restricts consumption and encourages saving; a man may merely think he is replacing capital, when he is actually making an added investment in the business.
Credit contraction will have another beneficial effect in promoting recovery. For bank credit expansion, we have seen, distorts the free market by lowering price differentials (the "natural rate of interest" or going rate of profit) on the market. Credit contraction, on the other hand, distorts the free market in the reverse direction. Deflationary credit contraction's first effect is to lower the money supply in the hands of business, particularly in the higher stages of production. This reduces the demand for factors in the higher stages, lowers factor prices and incomes, and increases price differentials and the interest rate. It spurs the shift of factors, in short, from the higher to the lower stages. But this means that credit contraction, when it follows upon credit expansion, speeds the market's adjustment process. Credit contraction returns the economy to free-market proportions much sooner than otherwise.
But, it may be objected, may not credit contraction overcompensate the errors of the boom and itself cause distortions that need correction? It is true that credit contraction may overcompensate, and, while contraction proceeds, it may cause interest rates to be higher than free-market levels, and investment lower than in the free market. But since contraction causes no positive mal-investments, it will not lead to any painful period of depression and adjustment. If businessmen are misled into thinking that less capital is available for investment than is really the case, no lasting damage in the form of wasted investments will ensue.Some readers may ask: why doesn't credit contraction lead to malinvestment, by causing overinvestment in lower-order goods and underinvestment in higher-order goods, thus reversing the consequences of credit expansion? The answer stems from the Austrian analysis of the structure of production. There is no arbitrary choice of investing in lower or higher-order goods. Any increased investment must be made in the higher-order goods, must lengthen the structure of production. A decreased amount of investment in the economy simply reduces higher-order capital. Thus, credit contraction will cause not excess of investment in the lower orders, but simply a shorter structure than would otherwise have been established. Furthermore, in the nature of things, credit contraction is severely limited—it cannot progress beyond the extent of the preceding inflation.In a gold standard economy, credit contraction is limited by the total size of the gold stock. Credit expansion faces no such limit.
Government Depression Policy: Laissez-Faire If government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt? The first and clearest injunction is: don't interfere with the market's adjustment process. The more the government intervenes to delay the market's adjustment, the longer and more grueling the depression will be, and the more difficult will be the road to complete recovery. Government hampering aggravates and perpetuates the depression. Yet, government depression policy has always (and would have even more today) aggravated the very evils it has loudly tried to cure. If, in fact, we list logically the various ways that government could hamper market adjustment, we will find that we have precisely listed the favorite "anti-depression" arsenal of government policy. Thus, here are the ways the adjustment process can be hobbled:
Prevent or delay liquidation. Lend money to shaky businesses, call on banks to lend further, etc.
Inflate further. Further inflation blocks the necessary fall in prices, thus delaying adjustment and prolonging depression. Further credit expansion creates more malinvestments, which, in their turn, will have to be liquidated in some later depression. A government "easy money" policy prevents the market's return to the necessary higher interest rates.
Keep wage rates up. Artificial maintenance of wage rates in a depression insures permanent mass unemployment. Furthermore, in a deflation, when prices are falling, keeping the same rate of money wages means that real wage rates have been pushed higher. In the face of falling business demand, this greatly aggravates the unemployment problem.
Keep prices up. Keeping prices above their free-market levels will create unsalable surpluses, and prevent a return to prosperity.
Stimulate consumption and discourage saving. We have seen that more saving and less consumption would speed recovery; more consumption and less saving aggravate the shortage of saved-capital even further. Government can encourage consumption by "food stamp plans" and relief payments. It can discourage savings and investment by higher taxes, particularly on the wealthy and on corporations and estates. As a matter of fact, any increase of taxes and government spending will discourage saving and investment and stimulate consumption, since government spending is all consumption. Some of the private funds would have been saved and invested; all of the government funds are consumed.In recent years, particularly in the literature on the "under-developed countries," there has been a great deal of discussion of government "investment." There can be no such investment, however. "Investment" is defined as expenditures made not for the direct satisfaction of those who make it, but for other, ultimate consumers. Machines are produced not to serve the entrepreneur, but to serve the ultimate consumers, who in turn remunerate the entrepreneurs. But government acquires its funds by seizing them from private individuals; the spending of the funds, therefore, gratifies the desires of government officials. Government officials have forcibly shifted production from satisfying private consumers to satisfying themselves; their spending is therefore pure consumption and can by no stretch of the term be called "investment." (Of course, to the extent that government officials do not realize this, their "consumption" is really waste-spending.) Any increase in the relative size of government in the economy, therefore, shifts the societal consumption-investment ratio in favor of consumption, and prolongs the depression.
Subsidize unemployment. Any subsidization of unemployment (via unemployment "insurance," relief, etc.) will prolong unemployment indefinitely, and delay the shift of workers to the fields where jobs are available.
These, then, are the measures which will delay the recovery process and aggravate the depression. Yet, they are the time-honored favorites of government policy, and, as we shall see, they were the policies adopted in the 1929-1933 depression, by a government known to many historians as a "laissez-faire" administration.
Since deflation also speeds recovery, the government should encourage, rather than interfere with, a credit contraction. In a gold-standard economy, such as we had in 1929, blocking deflation has further unfortunate consequences. For a deflation increases the reserve ratios of the banking system, and generates more confidence in citizen and foreigner alike that the gold standard will be retained. Fear for the gold standard will precipitate the very bank runs that the government is anxious to avoid. There are other values in deflation, even in bank runs, which should not be overlooked. Banks should no more be exempt from paying their obligations than is any other business. Any interference with their comeuppance via bank runs will establish banks as a specially privileged group, not obligated to pay their debts, and will lead to later inflations, credit expansions, and depressions. And if, as we contend, banks are inherently bankrupt and "runs" simply reveal that bankruptcy, it is beneficial for the economy for the banking system to be reformed, once and for all, by a thorough purge of the fractional-reserve banking system. Such a purge would bring home forcefully to the public the dangers of fractional-reserve banking, and, more than any academic theorizing, insure against such banking evils in the future.For more on the problems of fractional-reserve banking, see below.
The most important canon of sound government policy in a depression, then, is to keep itself from interfering in the adjustment process. Can it do anything more positive to aid the adjustment? Some economists have advocated a government-decreed wage cut to spur employment, e.g., a 10 percent across-the-board reduction. But free-market adjustment is the reverse of any "across-the-board" policy. Not all wages need to be cut; the degree of required adjustments of prices and wages differs from case to case, and can only be determined on the processes of the free and unhampered market.See W.H. Hutt, "The Significance of Price Flexibility," in Henry Hazlitt, ed., The Critics of Keynesian Economics (Princeton, N.J.: D. Van Nostrand, 1960), pp. 390–92. Government intervention can only distort the market further.
There is one thing the government can do positively, however: it can drastically lower its relative role in the economy, slashing its own expenditures and taxes, particularly taxes that interfere with saving and investment. Reducing its tax-spending level will automatically shift the societal saving-investment-consumption ratio in favor of saving and investment, thus greatly lowering the time required for returning to a prosperous economy.I am indebted to Mr. Rae C. Heiple, II, for pointing this out to me. Reducing taxes that bear most heavily on savings and investment will further lower social time preferences.Could government increase the investment-consumption ratio by raising taxes in any way? It could not tax only consumption even if it tried; it can be shown (and Prof. Harry Gunnison Brown has gone a long way to show) that any ostensible tax on "consumption" becomes, on the market, a tax on incomes, hurting saving as well as consumption. If we assume that the poor consume a greater proportion of their income than the rich, we might say that a tax on the poor used to subsidize the rich will raise the saving-consumption ratio and thereby help cure a depression. On the other hand, the poor do not necessarily have higher time preferences than the rich, and the rich might well treat government subsidies as special windfalls to be consumed. Furthermore, Harold Lubell has maintained that the effects of a change in income distribution on social consumption would be negligible, even though the absolute proportion of consumption is greater among the poor. See Harry Gunnison Brown, "The Incidence of a General Output or a General Sales Tax," Journal of Political Economy (April, 1939): 254–62; Harold Lubell, "Effects of Redistribution of Income on Consumers' Expenditures," American Economic Review (March, 1947): 157–70. Furthermore, depression is a time of economic strain. Any reduction of taxes, or of any regulations interfering with the free market, will stimulate healthy economic activity; any increase in taxes or other intervention will depress the economy further.
In sum, the proper governmental policy in a depression is strict laissez-faire, including stringent budget slashing, and coupled perhaps with positive encouragement for credit contraction. For decades such a program has been labeled "ignorant," "reactionary," or "Neanderthal" by conventional economists. On the contrary, it is the policy clearly dictated by economic science to those who wish to end the depression as quickly and as cleanly as possible.Advocacy of any governmental policy must rest, in the final analysis, on a system of ethical principles. We do not attempt to discuss ethics in this book. Those who wish to prolong a depression, for whatever reason, will, of course, enthusiastically support these government interventions, as will those whose prime aim is the accretion of power in the hands of the state.
It might be objected that depression only began when credit expansion ceased. Why shouldn't the government continue credit expansion indefinitely? In the first place, the longer the inflationary boom continues, the more painful and severe will be the necessary adjustment process, Second, the boom cannot continue indefinitely, because eventually the public awakens to the governmental policy of permanent inflation, and flees from money into goods, making its purchases while the dollar is worth more than it will be in future. The result will be a "runaway" or hyperinflation, so familiar to history, and particularly to the modern world.For the classic treatment of hyperinflation, see Costantino Bresciani-Turroni, The Economics of Inflation (London: George Allen and Unwin, 1937). Hyperinflation, on any count, is far worse than any depression: it destroys the currency—the lifeblood of the economy; it ruins and shatters the middle class and all "fixed income groups"; it wreaks havoc unbounded. And furthermore, it leads finally to unemployment and lower living standards, since there is little point in working when earned income depreciates by the hour. More time is spent hunting goods to buy. To avoid such a calamity, then, credit expansion must stop sometime, and this will bring a depression into being.
Preventing Depressions Preventing a depression is clearly better than having to suffer it. If the government's proper policy during a depression is laissez-faire, what should it do to prevent a depression from beginning? Obviously, since credit expansion necessarily sows the seeds of later depression, the proper course for the government is to stop any inflationary credit expansion from getting under way. This is not a very difficult injunction, for government's most important task is to keep itself from generating inflation. For government is an inherently inflationary institution, and consequently has almost always triggered, encouraged, and directed the inflationary boom. Government is inherently inflationary because it has, over the centuries, acquired control over the monetary system. Having the power to print money (including the "printing" of bank deposits) gives it the power to tap a ready source of revenue. Inflation is a form of taxation, since the government can create new money out of thin air and use it to bid away resources from private individuals, who are barred by heavy penalty from similar "counterfeiting." Inflation therefore makes a pleasant substitute for taxation for the government officials and their favored groups, and it is a subtle substitute which the general public can easily—and can be encouraged to—overlook. The government can also pin the blame for the rising prices, which are the inevitable consequence of inflation, upon the general public or some disliked segments of the public, e.g., business, speculators, foreigners. Only the unlikely adoption of sound economic doctrine could lead the public to pin the responsibility where it belongs: on the government itself.
Private banks, it is true, can themselves inflate the money supply by issuing more claims to standard money (whether gold or government paper) than they could possibly redeem. A bank deposit is equivalent to a warehouse receipt for cash, a receipt which the bank pledges to redeem at any time the customer wishes to take his money out of the bank's vaults. The whole system of "fractional-reserve banking" involves the issuance of receipts which cannot possibly be redeemed. But Mises has shown that, by themselves, private banks could not inflate the money supply by a great deal.See Mises, Human Action, pp. 429–45, and Theory of Money and Credit (New Haven, Conn.: Yale University Press, 1953). In the first place, each bank would find its newly issued uncovered, or "pseudo," receipts (uncovered by cash) soon transferred to the clients of other banks, who would call on the bank for redemption. The narrower the clientele of each bank, then, the less scope for its issue of pseudo-receipts. All the banks could join together and agree to expand at the same rate, but such agreement would be difficult to achieve. Second, the banks would be limited by the degree to which the public used bank deposits or notes as against standard cash; and third, they would be limited by the confidence of the clients in their banks, which could be wrecked by runs at any time.
Instead of preventing inflation by prohibiting fractional-reserve banking as fraudulent, governments have uniformly moved in the opposite direction, and have step-by-step removed these free-market checks to bank credit expansion, at the same time putting themselves in a position to direct the inflation. In various ways, they have artificially bolstered public confidence in the banks, encouraged public use of paper and deposits instead of gold (finally outlawing gold), and shepherded all the banks under one roof so that they can all expand together. The main device for accomplishing these aims has been Central Banking, an institution which America finally acquired as the Federal Reserve System in 1913. Central Banking permitted the centralization and absorption of gold into government vaults, greatly enlarging the national base for credit expansion:When gold—formerly the banks' reserves—is transferred to a newly established Central Bank, the latter keeps only a fractional reserve, and thus the total credit base and potential monetary supply are enlarged. See C.A. Phillips, T.F. McManus, and R.W. Nelson, Banking and the Business Cycle (New York: Macmillan, 1937), pp. 24ff. it also insured uniform action by the banks through basing their reserves on deposit accounts at the Central Bank instead of on gold. Upon establishment of a Central Bank, each private bank no longer gauges its policy according to its particular gold reserve; all banks are now tied together and regulated by Central Bank action. The Central Bank, furthermore, by proclaiming its function to be a "lender of last resort" to banks in trouble, enormously increases public confidence in the banking system. For it is tacitly assumed by everyone that the government would never permit its own organ—the Central Bank—to fail. A Central Bank, even when on the gold standard, has little need to worry about demands for gold from its own citizens. Only possible drains of gold to foreign countries (i.e., by non-clients of the Central Bank) may cause worry.
The government assured Federal Reserve control over the banks by (1) granting to the Federal Reserve System (FRS) a monopoly over note issue; (2) compelling all the existing "national banks" to join the Federal Reserve System, and to keep all their legal reserves as deposits at the Federal ReserveMany "state banks" were induced to join the FRS by patriotic appeals and offers of free services. Even the banks that did not join, however, are effectively controlled by the System, for, in order to obtain paper money, they must keep reserves in some member bank.; and (3) fixing the minimum reserve ratio of deposits at the Reserve to bank deposits (money owned by the public). The establishment of the FRS was furthermore inflationary in directly reducing existing reserve-ratio requirements.The average reserve requirements of all banks before 1913 was estimated at approximately 21 percent. By mid-1917, when the FRS had fully taken shape, the average required ratio was 10 percent. Phillips et al. estimate that the inherent inflationary impact of the FRS (pointed out in footnote 23) increased the expansive power of the banking system three-fold. Thus, the two factors (the inherent impact, and the deliberate lowering of reserve requirements) combined to inflate the monetary potential of the American banking system six-fold as a result of the inauguration of the FRS. See Phillips, et al., Banking and the Business Cycle, pp. 23ff. The Reserve could then control the volume of money by governing two things: the volume of bank reserves, and the legal reserve requirements. The Reserve can govern the volume of bank reserves (in ways which will be explained below), and the government sets the legal ratio, but admittedly control over the money supply is not perfect, as banks can keep "excess reserves." Normally, however, reassured by the existence of a lender of last resort, and making profits by maximizing its assets and deposits, a bank will keep fully "loaned up" to its legal ratio.
While unregulated private banking would be checked within narrow limits and would be far less inflationary than Central Bank manipulation,The horrors of "wildcat banking" in America before the Civil War stemmed from two factors, both due to government rather than free banking: (1) Since the beginnings of banking, in 1814 and then in every ensuing panic, state governments permitted banks to continue operating, making and calling loans, etc. without having to redeem in specie. In short, banks were privileged to operate without paying their obligations. (2) Prohibitions on interstate branch banking (which still exist), coupled with poor transportation, prevented banks from promptly calling on distant banks for redemption of notes. the clearest way of preventing inflation is to outlaw fractional-reserve banking, and to impose a 100 percent gold reserve to all notes and deposits. Bank cartels, for example, are not very likely under unregulated, or "free" banking, but they could nevertheless occur. Professor Mises, while recognizing the superior economic merits of 100 percent gold money to free banking, prefers the latter because 100 percent reserves would concede to the government control over banking, and government could easily change these requirements to conform to its inflationist bias.Mises, Human Action, p. 440. But a 100 percent gold reserve requirement would not be just another administrative control by government; it would be part and parcel of the general libertarian legal prohibition against fraud. Everyone except absolute pacifists concedes that violence against person and property should be outlawed, and that agencies, operating under this general law, should defend person and property against attack. Libertarians, advocates of laissez-faire, believe that "governments" should confine themselves to being defense agencies only. Fraud is equivalent to theft, for fraud is committed when one part of an exchange contract is deliberately not fulfilled after the other's property has been taken. Banks that issue receipts to non-existent gold are really committing fraud, because it is then impossible for all property owners (of claims to gold) to claim their rightful property. Therefore, prohibition of such practices would not be an act of government intervention in the free market; it would be part of the general legal defense of property against attack which a free market requires.A common analogy states that banks simply count on people not redeeming all their property at once, and that engineers who build bridges operate also on the principle that not everyone in a city will wish to cross the bridge at once. But the cases are entirely different. The people crossing a bridge are simply requesting a service; they are not trying to take possession of their lawful property, as are the bank depositors. A more fitting analogy would defend embezzlers who would never have been caught if someone hadn't fortuitously inspected the books. The crime comes when the theft or fraud is committed, not when it is finally revealed., Perhaps a libertarian legal system would consider "general deposit warrants" (which allow a warehouse to return any homogeneous good to the depositor) as "specific deposit warrants," which, like bills of lading, pawn tickets, dock-warrants, etc. establish ownership to specific, earmarked objects. As Jevons stated, "It used to be held as a general rule of law, that any present grant or assignment of goods not in existence is without operation." See W. Stanley Jevons, Money and the Mechanism of Exchange (London: Kegan Paul, 1905), pp. 207–12. For an excellent discussion of the problems of a fractional-reserve money, see Amasa Walker, The Science of Wealth (3rd ed., Boston: Little, Brown, 1867), pp. 126–32, esp. pp. 139–41.
What, then, was the proper government policy during the 1920s? What should government have done to prevent the crash? Its best policy would have been to liquidate the Federal Reserve System, and to erect a 100 percent gold reserve money; failing that, it should have liquidated the FRS and left private banks unregulated, but subject to prompt, rigorous bankruptcy upon failure to redeem their notes and deposits. Failing these drastic measures, and given the existence of the Federal Reserve System, what should its policy have been? The government should have exercised full vigilance in not supporting or permitting any inflationary credit expansion. We have seen that the Fed—the Federal Reserve System—does not have complete control over money because it cannot force banks to lend up to their reserves; but it does have absolute anti-inflationary control over the banking system. For it does have the power to reduce bank reserves at will, and thereby force the banks to cease inflating, or even to contract if necessary. By lowering the volume of bank reserves and/or raising reserve requirements, the federal government, in the 1920s as well as today, has had the absolute power to prevent any increase in the total volume of money and credit. It is true that the FRS has no direct control over such money creators as savings banks, savings and loan associations, and life insurance companies, but any credit expansion from these sources could be offset by deflationary pressure upon the commercial banks. This is especially true because commercial bank deposits (1) form the monetary base for the credit extended by the other financial institutions, and (2) are the most actively circulating part of the money supply. Given the Federal Reserve System and its absolute power over the nation's money, the federal government, since 1913, must bear the complete responsibility for any inflation. The banks cannot inflate on their own; any credit expansion can only take place with the support and acquiescence of the federal government and its Federal Reserve authorities. The banks are virtual pawns of the government, and have been since 1913. Any guilt for credit expansion and the consequent depression must be borne by the federal government and by it alone.Some writers make a great to-do over the legal fiction that the Federal Reserve System is "owned" by its member banks. In practice, this simply means that these banks are taxed to help pay for the support of the Federal Reserve. If the private banks really "own" the Fed, then how can its officials be appointed by the government, and the "owners" compelled to "own" the Federal Reserve Board by force of government statute? The Federal Reserve Banks should simply be regarded as governmental agencies.
This excerpt is taken from the first chapters of Murray Rothbard's .America's Great Depression, published in 1963.
The Trump administration doled out $700 million in CARES “loans” to trucking firm Yellow. Now Yellow has gone bankrupt, and the taxpayers may foot the bill.
Original Article: "The Taxpayers Bailed Out Yellow Trucking. It Went Bankrupt Anyway."
The Biden Administration is attempting to do a victory lap for "Bidenomics", but the public isn't buying it. On this episode of Good Money, Dr. Jonathan Newman joins the show to talk about his doubts of a "soft landing" for the economy, and the lies being told to sell Central Bank Digital Currencies.
Jonathan Newman's article on CBDCs: Mises.org/GM18a Jonathan Newman's article on "Soft Landing" headlines from 2007: Mises.org/GM18b
Good Money listeners can order a special $5 book bundle that includes How To Think About the Economy and What Has Government Done to Our Money? with free shipping using promo code "GoodMoney" at Mises.org/Good
Receive a free subscription to The Austrian magazine at Mises.org/Magazine
What is a business cycle?
Download lectures slides at Mises.org/MU23_PPT_14.
Recorded at the Mises Institute in Auburn, Alabama, on 25 July 2023.
On this episode of Good Money with Tho Bishop, Ryan McMaken joins the show to talk about America's debt crisis. Tho and Ryan discuss both the damage done to the economy by runaway government spending, as well as how Federal Reserve policy has incentivized consumption and punished savings, which has resulted in record-high credit card debt.
Good Money listeners can order a special $5 book bundle that includes How To Think About the Economy and What Has Government Done to Our Money? with free shipping using promo code "GoodMoney" at Mises.org/Good
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As the Fed increases interest rates to reverse the inflation it has caused, firms that depended on easy money will face the bankruptcy judge. Stay tuned; there's more to come.
Original Article: "The Bankruptcy Caravan Is Now Arriving: Time to Pay for the Easy Money"
One of the reasons that most economists of the 1920s did not recognize the existence of an inflationary problem was the widespread adoption of a stable price level as the goal and criterion for monetary policy. The extent to which the Federal Reserve authorities were guided by a desire to keep the price level stable has been a matter of considerable controversy. Far less controversial is the fact that more and more economists came to consider a stable price level as the major goal of monetary policy. The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the Great Depression caught them completely unaware.
Actually, bank-credit expansion creates its mischievous effects by distorting price relations and by raising and altering prices compared to what they would have been without the expansion. Statistically, therefore, we can only identify the increase in money supply, a simple fact. We cannot prove inflation by pointing to price increases. We can only approximate explanations of complex price movements by engaging in a comprehensive economic history of an era—a task which is beyond the scope of this study. Suffice it to say here that the stability of wholesale prices in the 1920s was the result of monetary inflation offset by increased productivity, which lowered costs of production and increased the supply of goods.
But this "offset" was only statistical. It did not eliminate the boom-bust cycle; it only obscured it. The economists who emphasized the importance of a stable price level were thus especially deceived, for they should have concentrated on what was happening to the supply of money. Consequently, the economists who raised an alarm over inflation in the 1920s were largely the qualitativists. They were written off as hopelessly old-fashioned by the "newer" economists who realized the overriding importance of the quantitative in monetary affairs. The trouble did not lie with particular credit on particular markets (such as stock or real estate); the boom in the stock and real-estate markets reflected Mises's trade cycle: a disproportionate boom in the prices of titles to capital goods, caused by the increase in money supply attendant upon bank credit expansion.The qualitative aspect of credit is important to the extent that bank loans must be to business, and not to government or to consumers, to put the trade cycle mechanism into motion.
The stability of the price level in the 1920s is demonstrated by the Bureau of Labor Statistics Index of Wholesale Prices, which fell to 93.4 (100 = 1926) in June 1921, rose slightly to a peak of 104.5 in November 1925, and then fell back to 95.2 by June 1929. The price level, in short, rose slightly until 1925 and fell slightly thereafter. Consumer price indices also behaved in a similar manner.The National Industrial Conference Board (NICB) consumer price index rose from 102.3 (1923 = 100) in 1921 to 104.3 in 1926, then fell to 100.1 in 1929; the Bureau of Labor Statistics (BLS) consumer good index fell from 127.7 (1935–1939 = 100) in 1921 to 122.5 in 1929. Historical Statistics of the U.S., 1789–1945 (Washington, D.C.: U.S. Department of Commerce, 1949), pp. 226–36, 344. On the other hand, the Snyder Index of the General Price Level, which includes all types of prices (real estate, stocks, rents, and wage rates, as well as wholesale prices) rose considerably during the period, from 158 in 1922 (1913 = 100) to 179 in 1929, a rise of 13 percent. Stability was therefore achieved only in consumer and wholesale prices, but these were and still are the fields considered especially important by most economic writers.
Within the overall aggregate of wholesale prices, foods and farm products rose over the period while metals, fuel, chemicals, and home furnishings fell considerably. That the boom was largely felt in the capital-goods industries can be seen by (a) the quadrupling of stock prices over the period, and by (b) the fact that durable goods and iron and steel production each increased by about 160 percent, while the production of non-durable goods (largely consumer goods) increased by only 60 percent.
In fact, production of such consumer items as manufactured foods and textile products increased by only 48 percent and 36 percent respectively, from 1921 to 1929. Another illustration of Mises's theory was that wages were bid up far more in the capital-goods industries. Overbidding of wage rates and other costs is a distinctive feature of Mises's analysis of capital-goods industries in the boom. Average hourly earnings, according to the Conference Board Index, rose in selected manufacturing industries from $.52 in July 1921 to $.59 in 1929, a 12 percent increase. Among this group, wage rates in consumer-goods industries such as boots and shoes remained constant; they rose 6 percent in furniture, less than 3 percent in meat packing, and 8 percent in hardware manufacturing. On the other hand, in such capital-goods industries as machines and machine tools, wage rates rose by 12 percent, and by 19 percent in lumber, 22 percent in chemicals, and 25 percent in iron and steel.
Federal Reserve credit expansion, then, whether so intended or not, managed to keep the price level stable in the face of an increased productivity that would, in a free and unhampered market, have led to falling prices and a spread of increased living standards to everyone in the population. The inflation distorted the production structure and led to the ensuing depression-adjustment period. It also prevented the whole populace from enjoying the fruits of progress in lower prices and insured that only those enjoying higher monetary wages and incomes could benefit from the increased productivity.
There is much evidence for the charge of Phillips, McManus, and Nelson that "the end-result of what was probably the greatest price-level stabilization experiment in history proved to be, simply, the greatest depression."C.A. Phillips, T.F. McManus, and R.W. Nelson, Banking and the Business Cycle (New York: Macmillan, 1937), pp. 176ff. Benjamin Strong was apparently converted to a stable-price-level philosophy during 1922. On January 11, 1925, Strong privately wrote,
that it was my belief, and I thought it was shared by all others in the Federal Reserve System, that our whole policy in the future, as in the past, would be directed toward the stability of prices so far as it was possible for us to influence prices.Lester V. Chandler, Benjamin Strong, Central Banker (Washington, D.C.: Brookings Institution, 1958), p. 312. In this view, Strong was, of course, warmly supported by Montagu Norman. Ibid., p. 315.
When asked, in the Stabilization Hearings of 1927, whether the Federal Reserve Board could "stabilize the price level to a greater extent" than in the past, by open-market operations and other control devices, Governor Strong answered,
I personally think that the administration of the Federal Reserve System since the reaction of 1921 has been just as nearly directed as reasonable human wisdom could direct it toward that very object.Also see ibid., pp. 199ff. And Charles Rist recalls that, in his private conversations, "Strong was convinced that he was able to fix the price level, by his interest and credit policy." Charles Rist, "Notice Biographique," Revue d'Èconomie Politique (November–December, 1955): 1029.
It appears that Governor Strong had a major hand, in early 1928, in drafting the bill by Representative James G. Strong of Kansas (no relation) to compel the Federal Reserve System to promote a stable price level.Strong thus overcame his previous marked skepticism toward any legislative mandate for price stabilization. Before this, he had preferred to leave the matter strictly to Fed discretion. See Chandler, Benjamin Strong, Central Banker, pp. 202ff. Governor Strong was ill by this time and out of control of the system, but he wrote the final draft of the bill along with Representative Strong. In the company of the congressman and professor John R. Commons, one of the leading theoreticians of a stable price level, Strong discussed the bill with members of the Federal Reserve Board. When the Board disapproved, Strong felt bound, in his public statements, to go along with them.See the account in Irving Fisher, ibid., pp. 170–71. Commons wrote of Governor Strong: "I admired him both for his open-minded help to us on the bill and his reservation that he must go along with his associates."
We must further note that Carl Snyder, a loyal and almost worshipful follower of Governor Strong, and head of the statistical department of the Federal Reserve Bank of New York, was a leading advocate of monetary and credit control by the Federal Reserve to stabilize the price level.See Fisher's eulogy of Snyder, Stabilised Money, pp. 64–67; and Carl Snyder, "The Stabilization of Gold: A Plan," American Economic Review (June, 1923): 276–85; idem, Capitalism the Creator (New York: Macmillan, 1940), pp. 226–28.
Certainly, the leading British economists of the day firmly believed that the Federal Reserve was deliberately and successfully stabilizing the price level. John Maynard Keynes hailed "the successful management of the dollar by the Federal Reserve Board from 1923 to 1928" as a "triumph" for currency management. D.H. Robertson concluded in 1929 that "a monetary policy consciously aimed at keeping the general price level approximately stable . . . has apparently been followed with some success by the Federal Reserve Board in the United States since 1922."D.H. Robertson, "The Trade Cycle," Encyclopaedia Britannica, 14th ed. (1929), vol. 22, p. 354. Whereas Keynes continued to hail the Reserve's policy a few years after the depression began, Robertson became critical,
Looking back . . . the great American "stabilization" of 1922–1929 was really a vast attempt to destabilize the value of money in terms of human effort by means of a colossal program of investment . . . which succeeded for a surprisingly long period, but which no human ingenuity could have managed to direct indefinitely on sound and balanced lines.D.H. Robertson, "How Do We Want Gold to Behave?" in The International Gold Problem (London: Humphrey Milford, 1932), p. 45; quoted in Phillips, et al., Banking and the Business Cycle, pp. 186–87.
The siren song of a stable price level had lured leading politicians, to say nothing of economists, as early as 1911. It was then that Professor Irving Fisher launched his career as head of the "stable money" movement in the United States. He quickly gained the adherence of leading statesmen and economists to a plan for an international commission to study the money and price problem.
Supporters included President William Howard Taft, Secretary of War Henry Stimson, Secretary of the Treasury Franklin MacVeagh, Governor Woodrow Wilson, Gifford Pinchot, seven senators, and economists Alfred Marshall, Francis Edgeworth, and John Maynard Keynes in England. President Taft sent a special message to Congress in February 1912, urging an appropriation for such an international conference. The message was written by Fisher, in collaboration with Assistant Secretary of State Huntington Wilson, a convert to stable money. The Senate passed the bill, but it died in the House. Woodrow Wilson expressed interest in the plan but dropped the idea in the press of other matters.
In the spring of 1918, a Committee on the Purchasing Power of Money of the American Economic Association endorsed the principle of stabilization. Though encountering banker opposition to his stable-money doctrine, led notably by A. Barton Hepburn of the Chase National Bank, Fisher began organizing the Stable Money League at the end of 1920, and established the League at the end of May 1921—at the beginning of our inflationary era. Newton D. Baker, secretary of war under Wilson, and Professor James Harvey Rogers of Cornell were two of the early organizers.
Other prominent politicians and economists who played leading roles in the Stable Money League were Professor Jeremiah W. Jenks, its first president; Henry A. Wallace, editor of Wallace's Farmer, and later secretary of agriculture; John G. Winant, later governor of New Hampshire; Professor John R. Commons, its second president; George Eastman of the Eastman-Kodak family; Lyman J. Gage, formerly secretary of the Treasury; Samuel Gompers, president of the American Federation of Labor; Senator Carter Glass of Virginia; Thomas R. Marshall, vice president of the United States under Wilson; Representative Oscar W. Underwood; Malcolm C. Rorty; and economists Arthur Twining Hadley, Leonard P. Ayres, William T. Foster, David Friday, Edwin W. Kemmerer, Wesley C. Mitchell, Warren M. Persons, H. Parker Willis, Allyn A. Young, and Carl Snyder.
The ideal of a stable price level is relatively innocuous during a price rise when it can aid sound-money advocates in trying to check the boom; but it is highly mischievous when prices are tending to sag, and the stabilizationists call for inflation. And yet, stabilization is always a more popular rallying cry when prices are falling. The Stable Money League was founded in 1920–1921, when prices were falling during a depression. Soon, prices began to rise, and some conservatives began to see in the stable money movement a useful check against extreme inflationists. As a result, the league changed its name to the National Monetary Association in 1923, and its officers continued as before, with Professor Commons as president.
By 1925, the price level had reached its peak and begun to sag, and consequently the conservatives abandoned their support of the organization, which again changed its name to the Stable Money Association. Successive presidents of the new association were H. Parker Willis, John E. Rovensky, executive vice president of the Bank of America, Professor Kemmerer, and "Uncle" Frederic W. Delano. Other eminent leaders in the Stable Money Association were Professor Willford I. King; President Nicholas Murray Butler of Columbia University; John W. Davis, Democratic candidate for president in 1924; Charles G. Dawes, director of the Bureau of the Budget under Harding, and vice president under Coolidge; William Green, president of the American Federation of Labor; Charles Evans Hughes, secretary of state until 1925; Otto H. Kahn, investment banker; Frank O. Lowden, former Republican governor of Illinois; Elihu Root, former secretary of state and senator; James H. Rand Jr.; Norman Thomas, of the Socialist Party; Paul M. Warburg; and Owen D. Young. Enlisting from abroad came Charles Rist of the Bank of France; Eduard Benes of Czechoslovakia; Max Lazard of France; Emile Moreau of the Bank of France; Louis Rothschild of Austria; and Sir Arthur Balfour, Sir Henry Strakosch, Lord Melchett, and Sir Josiah Stamp of Great Britain.
Serving as honorary vice presidents of the association were the presidents of the following organizations: the American Association for Labor Legislation, American Bar Association, American Farm Bureau Federation, American Farm Economic Association, American Statistical Association, Brotherhood of Railroad Trainmen, National Association of Credit Men, National Consumers' League, National Education Association, American Council on Education, United Mine Workers of America, the National Grange, the Chicago Association of Commerce, the Merchants' Association of New York, and Bankers' Associations in 43 states and the District of Columbia.
Executive director and operating head of the association with such formidable backing was Norman Lombard, brought in by Fisher in 1926. The association spread its gospel far and wide. It was helped by the publicity given to Thomas Edison and Henry Ford's proposal for a "commodity dollar" in 1922 and 1923. Other prominent stabilizationists in this period were professors George F. Warren and Frank Pearson of Cornell, Royal Meeker, Hudson B. Hastings, Alvin Hansen, and Lionel D. Edie. In Europe, in addition to the above mentioned, advocates of stable money included: Professor Arthur C. Pigou, Ralph G. Hawtrey, J.R. Bellerby, R.A. Lehfeldt, G.M. Lewis, Sir Arthur Salter, Knut Wicksell, Gustav Cassel, Arthur Kitson, Sir Frederick Soddy, F.W. Pethick-Lawrence, Reginald McKenna, Sir Basil Blackett, and John Maynard Keynes. Keynes was particularly influential in his propaganda for a "managed currency" and a stabilized price level, as set forth in his Tract on Monetary Reform, published in 1923.
Ralph Hawtrey proved to be one of the evil geniuses of the 1920s. An influential economist in a land where economists have shaped policy far more influentially than in the United States, Hawtrey, director of financial studies at the British Treasury, advocated international credit control by central banks to achieve a stable price level as early as 1913. In 1919, Hawtrey was one of the first to call for the adoption of a gold-exchange standard by European countries, tying it in with international central-bank cooperation. Hawtrey was one of the prime European trumpeters of the prowess of Governor Benjamin Strong.
Writing in 1932, at a time when Robertson had come to realize the evils of stabilization, Hawtrey declared, "The American experiment in stabilization from 1922 to 1928 showed that an early treatment could check a tendency either to inflation or to depression. . . . The American experiment was a great advance upon the practice of the nineteenth century," when the trade cycle was accepted passively.Ralph O. Hawtrey, The Art of Central Banking (London: Longmans, Green, 1932), p. 300. When Governor Strong died, Hawtrey called the event "a disaster for the world."Leading stabilizationist Norman Lombard also hailed Strong's alleged achievement: "By applying the principles expounded in this book . . . he [Strong] maintained in the United States a fairly stable price level and a consequent condition of widespread economic well-being from 1922 to 1928." Norman Lombard, Monetary Statesmanship (New York: Harpers, 1934), p. 32n. On the influence of stable price ideas on Federal Reserve policy, see also David A. Friedman, "Study of Price Theories Behind Federal Reserve Credit Policy, 1921–29" (unpublished M.A. thesis, Columbia University, 1938). Finally, Hawtrey was the main inspiration for the stabilization resolutions of the Genoa Conference of 1922.
It was inevitable that this host of fashionable opinion should be translated into legislative pressure, if not legislative action. Rep. T. Alan Goldsborough of Maryland introduced a bill to "Stabilize the Purchasing Power of Money" in May 1922, essentially Professor Fisher's proposal, fed to Goldsborough by former Vice President Marshall. Witnesses for the bill were Professors Fisher, Rogers, King, and Kemmerer, but the bill was not reported out of committee. In early 1924, Goldsborough tried again, and Representative O.B. Burtness of North Dakota introduced another stabilization bill. Neither was reported out of committee.
The next major effort was a bill by Rep. James G. Strong of Kansas, introduced in January, 1926, under the urging of veteran stabilizationist George H. Shibley, who had been promoting the cause of stable prices since 1896. Rather than the earlier Fisher proposal for a "compensated dollar" to manipulate the price level, the Strong Bill would have compelled the Federal Reserve System to act directly to stabilize the price level. Hearings were held from March 1926 until February 1927. Testifying for the bill were Shibley, Fisher, Lombard, Dr. William T. Foster, Rogers, Bellerby, and Commons. Commons, Rep. Strong, and Governor Strong then rewrote the bill, as indicated above, and hearings were held on the second Strong Bill in the spring of 1928.
The high point of testimony for the second Strong Bill was that of Sweden's Professor Gustav Cassel, whose eminence packed the Congressional hearing room. Cassel had been promoting stabilization since 1903. The advice of this sage was that the government employ neither qualitative nor quantitative measures to check the boom, since these would lower the general price level. In a series of American lectures, Cassel also urged lower Fed reserve ratios, as well as worldwide central-bank cooperation to stabilize the price level.
The Strong Bill met the fate of its predecessors, and never left the committee. But the pressure exerted at the various hearings for these bills, as well as the weight of opinion and the views of Governor Strong, served to push the Federal Reserve authorities into trying to manipulate credit for purposes of price stabilization.
International pressure strengthened the drive for a stable price level. Official action began with the Genoa Conference, in the spring of 1922. This Conference was called by the League of Nations, at the initiative of Premier Lloyd George, who in turn was inspired by the dominant figure of Montagu Norman. The Financial Commission of the Conference adopted a set of resolutions which, as Fisher puts it, "have for years served as the potent armory for the advocates of stable money all over the world."Fisher, Stabilised Money, p. 282. Our account of the growth of the stable money movement rests heavily upon Fisher's work. The resolutions urged international central-bank collaboration to stabilize the world price level, and also suggested a gold-exchange standard.
On the Financial Commission were such stabilizationist stalwarts as Sir Basil Blackett, Professor Cassel, Dr. Vissering, and Sir Henry Strakosch.While Hawtrey was the main inspiration for the resolutions, he criticized them for not going far enough. The League of Nations, indeed, was quickly taken over by the stabilizationists. The Financial Committee of the League was largely inspired and run by Governor Montagu Norman, working through two close associates, Sir Otto Niemeyer and Sir Henry Strakosch. Sir Henry was, as we have indicated, a prominent stabilizationist.See Paul Einzig, Montagu Norman (London: Kegan Paul, 1932), pp. 67, 78. Furthermore, Norman's chief adviser in international affairs, Sir Charles S. Addis, was also an ardent stablizationist. Sir Henry Clay, Lord Norman (London: Macmillan, 1957), p. 138.
In 1921, a Joint Committee on Economic Crises was formed by the General Labour Conference, the International Labour Office (ILO) of the League of Nations, and the Financial Committee of the League. On this Joint Committee were three leading stabilizationists: Albert Thomas, Henri Fuss, and Major J.R. Bellerby. In 1923, Thomas's report warned that a fall in the price level "almost invariably" causes unemployment. Henri Fuss of the ILO propagandized for stable price levels in the International Labour Review in 1926.
The Joint Committee met in June 1925 to affirm the principles of the Genoa Conference. In the meanwhile, two private international organizations, the International Association for Labour Legislation and the International Association on Unemployment, held a joint International Congress on Social Policy, at Prague, in October 1924. The congress called for the general adoption of the principles of the Genoa Conference, by stabilizing the general price level. The International Association for Social Progress adopted a report at its Vienna meeting in September 1928 prepared by stabilizationist Max Lazard of the investment banking house of Lazard Frères in Paris, calling for price-level stability. The ILO followed suit in June 1929 terming falling prices a cause of unemployment. And, finally, the Economic Consultative Committee of the league endorsed the Genoa principles in the summer of 1928.
Just as Professors Cassel and Commons wanted no credit restraint at all in 1928 and 1929, so Representative Louis T. McFadden, powerful chairman of the House Banking and Currency Committee, exerted a similar though more powerful brand of pressure on the Federal Reserve authorities. On February 7, 1929, the day after the Federal Reserve Board's letter to the Federal Reserve Banks warning about stock-market speculation, Representative McFadden himself warned the House against an adverse business reaction from this move. He pointed out that there had been no rise in the commodity price level, so how could there be any danger of inflation? The Fed, he warned skittishly, should not concern itself with the stock market or security loans, lest it produce a general slump. Tighter money would make capital financing difficult, and, coupled with the resulting loss of confidence, would precipitate a depression.
In fact, McFadden declared that the Fed should be prepared to ease money rates as soon as any fall in prices or employment might appear.Cited in Joseph Stagg Lawrence, Wall Street and Washington (Princeton, N.J.: Princeton University Press, 1929), pp. 437–43. Other influential voices raised against any credit restriction were those of W.T. Foster and Waddill Catchings, leading stabilizationists and well known for their underconsumptionist theories. Catchings was a prominent investment banker (of Goldman, Sachs and Co.), and iron and steel magnate, and both men were close to the Hoover administration. (As we shall see, their "plan" for curing unemployment was adopted, at one time, by Hoover.)
In April 1929 Foster and Catchings warned that any credit restriction would lower the price level and hurt business. The bull market, they assured the public—along with Fisher, Commons, and the rest—was grounded on a sure foundation of American confidence and growth.Commercial and Financial Chronicle (April, 1929): 2204–06. Also see Beckhart, "Federal Reserve Policy and the Money Market," in Beckhart et al., The New York Money Market (New York: Columbia University Press, 1931), vol. 2, pp. 99ff. And the bull speculators, of course, echoed the cry that everyone should "invest in America." Anyone who criticized the boom was considered to be unpatriotic and "selling America short."
Cassel was typical of European opinion in insisting on even greater inflationary moves by the Federal Reserve System. Sir Ralph Hawtrey, visiting at Harvard during 1928–1929, spread the gospel of price-level stabilization to his American audience.See Joseph Dorfman, The Economic Mind in American Civilization (New York: Viking Press, 1959), vol. 4, p. 178. Influential British Labourite Philip Snowden urged in 1927 that the United States join in a world plan for price stabilization, to prevent a prolonged price decline. The London Statist and the Nation (London) both bemoaned the Federal Reserve "deflation."
Perhaps most extreme was a wildly inflationist article by the respected economist Professor Allyn A. Young, an American then teaching at the University of London. Young, in January 1929, warned about the secular downward price trend, and urged all central banks not to "hoard" gold, to abandon their "high gold reserve-ratio fetish," and to inflate to a fare-thee-well. "Central banks of the world," he declared, "appear to be afraid of prosperity. So long as they are they will exert a retarding influence upon the growth of production."Allyn A. Young, "Downward Price Trend Probable, Due to Hoarding of Gold by Central Banks," The Annalist (January 18, 1929): 96–97. Also see, "Our Reserve Bank Policy as Europe Thinks It Sees It," The Annalist (September 2, 1927): 374–75.
In an age of folly, Professor Young's article was perhaps the crowning pièce de résistance—much more censurable than the superficially more glaring errors of such economists as Irving Fisher and Charles A. Dice on the alleged "new era" prosperity of the stock market. Merely to extrapolate present stock market conditions is, after all, not nearly as reprehensible as considering deflation the main threat in the midst of a rampantly inflationary era. But such was the logical conclusion of the stabilizationist position.
We may conclude that the Federal Reserve authorities, in promulgating their inflationary policies, were motivated not only by the desire to help British inflation and to subsidize farmers, but were also guided—or rather misguided—by the fashionable economic theory of a stable price level as the goal of monetary manipulation.Seymour Harris, Twenty Years of Federal Reserve Policy (Cambridge, Mass.: Harvard University Press, 1933), vol. 1, 192ff., and Aldrich, The Causes of the Present Depression and Possible Remedies (New York, 1933), pp. 20–21.
This article is excerpted from America's Great Depression, part 2, chapter 6, "Theory and Inflation: Economists and the Lure of a Stable Price Level" (1963; 2008).
Bob originally invited Brian Albrecht (Chief Economist of the International Center for Law & Economics) to discuss the work of Armen Alchian, but on the day of recording, Robert Lucas happened to die.
Bob and Brian discuss rational expectations, real business cycle theory, and how Alchian cracked the military's top secrets.
Brian on Alchian's famous "Costs and Outputs" paper: Mises.org/HAP396a
Austrian business cycle theory points out that easy money leads to malinvestments. Once easy money disappears, the crash begins. Time to clean up malinvested assets.
Original Article: "Paying the Piper: Time to Clean Up the Latest Malinvestments"
Dr. Paul Cwik joins Bob to discuss the inverted yield curve's "signal" of an impending recession.
Dr. Cwik's dissertation on inverted yield curves and economic downturns: Mises.org/HAP395a
Bob on the link between inverted yield curves and recessions: Mises.org/HAP395b
Bob's Understanding Money Mechanics: Mises.org/Mechanics
After years of inflationary intervention, the Federal Reserve has no more rabbits to pull out of the hat.
Original Article: "The Failure of the Federal Reserve: The Covid Boom and Unnecessary Intervention"
While the Biden White House claims we are on a steady course of prosperity, the more realistic future is that of a global recession.
Original Article: "The Coming Recession Will Be a Global One"
This Audio Mises Wire is generously sponsored by Christopher Condon.
At the heart of Keynesian business cycle theory is the so-called liquidity trap. Contra Keynes, however, economies don't falter because a sudden increase in the demand for money.
Original Article: "Forget the Liquidity Trap—Loose Monetary Policies Cause Recessions"
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Economists and pundits mistakenly call the Federal Reserve System's security holdings a portfolio. It is anything but.
Original Article: "The Fed’s Portfolio Is Nonexistent: The Fed Does Not Invest. It Destroys Investments"
This Audio Mises Wire is generously sponsored by Christopher Condon.
While an increase in the supply of gold money would lead to higher consumer prices, such increases in the gold supply do not lead to boom-bust cycles.
Original Article: "Can Increases in the Supply of Gold Lead to Boom-Bust Cycles?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
For nearly two decades, business, academic, and political elites have spread the fiction that central banks can engineer prosperity by printing more money. Markets now are discrediting that fairy tale.
Original Article: "The Corporate Fairy Tale Is Dying as Economic Reality Sets In"
This Audio Mises Wire is generously sponsored by Christopher Condon.
A serious political discussion at the federal level would center on structural problems of war and peace, debt and the dollar, and entitlements. But America in 2022 is a deeply unserious country.
Original Article: "Can a Deeply Unserious America Fix Its Economy?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Ending the string of economic crises that have occurred the past two decades will happen only when economies can depend upon sound money.
Original Article: "Eliminating Economic Crises"
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As the inevitable economic downturn becomes more evident, the Fed will attempt to stop deflation. But what this economy needs is a good dose of it.
Original Article: "Black Hole or Shock Absorber: How Does a Free-Market Economy Respond to Crises?"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
Most economists see GDP as a snapshot of the performance of the economy. However, it is better understood as a misleading statistic which fails to accurately describe what really is happening economically.
Original Article: "GDP Provides a False Reading of the State of the Economy"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Mortgage companies and realtors are today's canaries. They're in deep trouble, and so are the rest of us.
Original Article: "The Canaries in the Coal Mines Are No Longer Singing"
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Download the slides from this lecture at Mises.org/MU22_PPT_14.
Recorded at the Mises Institute in Auburn, Alabama, on 26 July 2022.
The Federal Reserve is raising interest rates and we know what follows, given there has been more than a decade of malinvestments building up: severe recession.
Original Article: "Economic Winter Has Arrived"
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The Fed's reckless behavior has undermined Netflix more than the losses at CNN+.
Original Article: "How Did CNN+ Get Canned by Netflix? Austrian Economists Might Have an Answer"
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Despite assurances from politicians and the media, the Federal Reserve System is not a collection of geniuses who stand guard against inflation and recession. Instead, think of the Fed policy makers as the Keystone Cops of central banking.
Original Article: "The Fed Can't Fix the Economy, but It Can Break It"
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Abstract: In response to the COVID-19 lockdown policies, Guerrieri et al. (2020) developed a new concept: the Keynesian supply shock. A Keynesian supply shock is an aggregate supply shock that leads to an even larger aggregate demand shock. This paper suggests that Keynesian supply shocks are very similar to the secondary deflations suggested by Hayek (1931), and US data from the 2007–09 financial crisis show that these concepts may help to explain employment dynamics in the midst of a crisis. This fact implies that long-standing policy advice based on Austrian business cycle theory would be useful in responding to Keynesian supply shocks.
JEL Classification: E32, B53
Lucas M. Engelhardt (lengelha@kent.edu) is an associate professor at Kent State University’s Stark campus and a fellow of the Mises Institute.
The economic impacts of COVID-19 and the policies surrounding it have provided the grounds for extensive work in economics, especially surrounding public policy responses to the pandemic. Much of this work (for example, Eichenbaum, Rebelo, and Trabandt 2020) is based on integrating epidemiology models into standard models of macroeconomic activity. However, one exception to this trend is the introduction of a seemingly new, and possibly more generalizable, idea: “Keynesian supply shocks” (Guerrieri, et al. 2020). Keynesian supply shocks are shocks to aggregate supply that, in turn, lead to a shock to aggregate demand that is even larger than the original supply shock, so that the demand shock dominates the macroeconomic dynamics. Put another way, a Keynesian supply shock is a supply shock with a traditional demand-side multiplier. This new concept calls into question the separability of aggregate supply and aggregate demand.
This paper suggests that there is a significant conceptual overlap between Keynesian supply shocks and Hayek’s concept of a “secondary deflation,” in which an initial crisis focused on the liquidation of malinvestments leads to economy-wide consequences (Hayek 1931). If the two concepts are related, then the work on Keynesian supply shocks provides an additional approach that Austrian business cycle theorists can draw from for empirical illustrations, and Austrian business cycle theory has implications for policy prescriptions when dealing with the resulting recessions. Because Keynesian supply shocks are a new concept, there is very little literature directly connected with them yet. This paper serves as an early attempt to bring this concept into contact with the much older Hayekian “secondary deflation.”
In addition to explaining the theoretical overlap between Keynesian supply shocks and Hayekian secondary depressions, this paper will show that employment data from the United States during the 2007–09 financial crisis is more consistent with the Keynesian supply shock/Hayekian secondary deflation theory than is employment data from the 2020 COVID-19 lockdowns, which inspired Guerrieri et al. (2020) to develop the Keynesian supply shock concept. This observation suggests that these two concepts have an applicability that is not bound by the rather odd case of the COVID-19 crisis.
“KEYNESIAN” SUPPLY SHOCKS What is a “Keynesian supply shock”? In short, a Keynesian supply shock is a supply shock that causes a decrease in aggregate demand that is larger than the original supply shock (Guerrieri, et al. 2020). If we think in terms of standard aggregate supply–aggregate demand analysis, a Keynesian supply shock would create a leftward shift in both aggregate supply and aggregate demand, with the aggregate demand shift dominating. The result is a more severe recession than either shock alone would have caused, but also a decrease in the price level. As a result, if analysts casually observe price levels and real gross domestic product (GDP) levels, they will conclude that an aggregate demand shock was the primary force driving macroeconomic dynamics, when in fact the underlying cause of the demand shock is the shock to aggregate supply.
The motivation for the idea of a Keynesian supply shock was the shutdown of nonessential businesses in many places in the world during the coronavirus pandemic, especially during the early phases (for example, Michigan’s Executive Order 2020-42, which closed all in-person work which was “not necessary to sustain or protect life”). Guerrieri et al. (2020) find that, under specific conditions, the partial shutdown of supply can lead to a demand shock that is more severe than the direct impact of the supply shock itself.
Guerrieri et al. (2020) model the shutdown as a temporary decrease in labor supply, and judge whether the aggregate supply or aggregate demand shock dominates by considering the effect on the natural rate of interest.They also evaluate how labor demand would compare to labor supply if wages and prices were fixed and the rate of interest were not allowed to move to its natural level, though this layer of analysis does not change the broader analysis. In their model, the discount rate is kept constant so that the natural rate of interest will vary because of changes in the marginal utility of consumption. If the marginal utility of consumption for the present period rises relative to the expected future marginal utility of consumption, then the natural interest rate rises (consistent with the argument of Böhm-Bawerk [1930]), which is interpreted as being consistent with the dominance of the aggregate supply shock, because the relatively high marginal utility of present consumption indicates that there is a significant unsatisfied demand for present consumption goods. On the other hand, if the marginal utility of consumption for the present period falls relative to the future marginal utility of consumption, then the natural interest rate falls, which is interpreted as being consistent with the dominance of the aggregate demand shock.
First, they consider a case in which there is a single sector which is partially shut down by lockdown orders.They consider both “complete” markets—where there is an insurance program or lending market that evenly distributes any changes in employment opportunities—and “incomplete” markets, in which some workers face borrowing constraints. However, the qualitative results are the same for these two cases. Here, one can consider a number of ways that the results could work out. First, the decrease in available consumption goods would tend to increase the natural rate of interest, as consumers expect an increase in consumption in future periods when the shutdown ends, leading to a relatively higher marginal utility of (relatively more scarce) current consumption when compared to the marginal utility of (relatively more abundant) future consumption. Looking at the phenomenon from another angle, the shock to labor supply would lead to an increase in equilibrium wages. In terms of total income, the increase in wages would at least partially offset the decrease in employment, so that there is not much of a decrease in aggregate demand—leading supply effects to dominate. The only exception is if laid-off workers decrease their consumption in proportion with their lost income, in which case the supply shock is matched by an equal demand shock such that the natural rate of interest is unchanged. However, this is unlikely in reality because laid-off workers tend to borrow or spend from their savings in anticipation of an improvement in labor markets when the shutdown ends, in addition to partaking of any unemployment insurance or other government relief measures that are likely to be made available (such as that provided by the 2020 Coronavirus Aid, Relief, and Economic Security [CARES] Act in the United States.One could also observe that consuming nothing when income drops to zero would soon result in death—a fairly powerful incentive to maintain nonzero consumption even if earned income has fallen to zero. In brief: if the entire economy is a single sector which is partially shut down by lockdowns, supply shocks are not “Keynesian”—they do not lead to significant shocks in aggregate demand. Notably, modeling the economy based on a “representative firm”—which effectively treats the economy as a single sector—is a common practice in mainstream macroeconomics.
However, in a two-sector economy, the story changes. In this version of the model, employees completely specialize in one of two sectors, and the shutdown affects just one sector (the “nonessential”), leaving the other (“essential”) sector to operate as usual. So, consumers are forced to go without the products of the nonessential sector but can continue consuming from the essential sector as normal. In this case, what happens to demand depends on two parameters: the parameter that governs consumers’ willingness to substitute consumption across time, and the parameter that governs the relationship between the goods produced by the two sectors. First, the more willing people are to substitute consumption across time, the larger the negative impact on the essential sector will be—as those workers that are laid off when the nonessential sector shuts down simply wait to consume until later periods. Second, if the goods from the essential sector and the nonessential sector are complements in consumption, then a negative impact on aggregate demand arising from the supply shock is more likely. Since the good from the nonessential business is no longer available, people have less demand for the complementary good from the essential business. In short, the loss of the nonessential good decreases the current marginal utility of the essential good, which can drive down the natural interest rate. If, on the other hand, people are not willing to substitute consumption across time and the two goods are substitutes, then consumers will tend to significantly increase their demand for the essential good to maintain current overall consumption during the lockdown, so that the supply shock does not create a “Keynesian” ripple effect on aggregate demand. Put another way, when the goods are substitutes, the loss of one good increases the marginal utility of the other—leading to a higher natural interest rate, reflecting the dominance of the aggregate supply shock.
The above applies in the model which assumes “complete markets” (that is, markets where workers have unemployment insurance or largely unconstrained credit, so that any fall in current consumption is divided equally among workers). Once the fact that markets are “incomplete”—that is, that lost income is mostly going to be experienced by those that are laid off because of the shutdown policies—is accounted for, the conditions that lead to decreased aggregate demand are widened. That is, some scenarios that would lead to “standard” supply shocks if markets were complete end up with significant Keynesian demand ripples because of the severe loss of income (and therefore decrease in consumption) for those employed in the nonessential sector, who have no choice but to decrease their consumption because of the diminished availability of unemployment insurance or lending markets in this model.
In another version of the model, the possibility of labor mobility between sectors is introduced. In this case, the demand shock is more likely to dominate than when labor mobility is limited. As workers flood the sector that is still open, the good produced by the essential sector experiences a temporary boom, which tends to push down the current marginal utility of consumption, and therefore tends to push down the natural interest rate. Put another way: the ability of workers to move between sectors offsets the severity of the supply shock, allowing the demand effects to dominate.
Guerrieri et al. also consider a case of a “demand chain” in which nonessential businesses purchase services from essential businesses. For example, restaurants (which have been severely hampered by lockdown policies [Honan and Vielkind 2020]) sometimes purchase the services of accounting firms (which may be considered “essential” simply because they can operate with minimal physical contact). In this case, the loss of nonessential clients during the shutdown can end up having additional demand-side effects for essential businesses, making large “Keynesian” ripples more likely. Notably, they do not consider a case in which essential businesses purchase services from nonessential businesses—though in that case the supply shock would be magnified through the supply channel, as those businesses that rely on inputs from the shut-down nonessential businesses would find their own supply constrained. For example, if farmers (which are considered essential) purchase work gloves from garden supply stores (which were deemed nonessential in some areas), then the productivity of farmers would decline, so that the supply shock would ripple through the structure of production but would maintain a supply shock nature. Amid the COVID-19 crisis, some jurisdictions recognized the difficulties this could cause, and so considered suppliers of any essential business to also be essential. For example, Ohio’s stay-at-home order included “Businesses that sell, manufacture, or supply other Essential Businesses and Operations with support or materials necessary to operate” on the list of essential businesses.
Finally, they consider a model with a multitude (technically, a continuum) of sectors in which there may be “exit cascades.” In this model, the shutdown of one sector leads to a decline in demand which can result in another sector being unable to cover its fixed costs of operation, leading at least some firms in that sector to shut down as well, leading to a further decline in demand for the remaining firms and further exits. These ripples can create significant demand-side effects.
Summarizing the findings of Guerrieri et al. (2020), if there are multiple sectors in the economy, the supply shock caused by the shutdown of one sector can create demand-side effects that are more significant than the original shutdown. These demand-side effects are magnified to the extent that (1) employees of the shut-down industry have incomplete protection against losses of wages, (2) the goods produced by the shut-down sector are complementary to the goods produced by other sectors, (3) consumers are more willing to shift consumption across time, (4) labor can reallocate itself across sectors, (5) the shut-down sectors are an important source of demand for the sectors continuing to operate, and (6) exit cascades occur. Since multiple sectors do exist, and at least some of these magnifying factors are plausible, it is reasonable to believe that supply shocks may end up turning “Keynesian” in many cases.
AUSTRIAN BUSINESS CYCLES AND SECONDARY DEFLATION AND DEPRESSION At heart, Austrian business cycle theory is about a misallocation of resources between sectors (that is, “malinvestment”). During a period of credit expansion, entrepreneurs invest in production processes that are expected to be profitable, though they will ultimately end up being unprofitable. When the period of credit expansion ends, the errors of the entrepreneurs are revealed, resulting in a recognition that production must be restructured to eliminate the misallocation of capital.
An important element of the Austrian approach is that Austrians generally expect that misallocation will be most severe in specific sectors of the economy—that is, a multiple sector approach is an essential component of the Austrian explanation for business cycles. “Capital intensive” sectors that are early in the stages of production will be heavily affected, as these sectors are more sensitive to distortions in interest rates than others. Typically, this set of sectors would include fields such as research and development or raw material production, which are likely to result in consumer goods only after a long period of time. Housing is another example of the type of good that may be vulnerable during Austrian business cycles. Although housing may appear to be a consumer good, it provides housing services over a very long period—decades or sometimes centuries—so that a new home is at an early stage in the production of housing services.
How can one translate the Austrian-style crisis and collapse into aggregate supply and aggregate demand terms? Generally, Austrians are fast to point out that aggregation will tend to cover up the important dynamics (for example, Hayek 1935), and therefore obscure what is happening within the capital structure. This is consistent with the findings of Guerrieri et al. (2020). In their models, when sectors are aggregated into a single sector, the possibility of a Keynesian supply shock vanishes—so aggregation covers up the important dynamics in their model, even if the dynamics are more connected to employment than to capital structure. Despite the differences in the theoretical foundations of aggregate supply–aggregate demand analysis and the Austrian approach, one can think of the aggregate supply–aggregate demand approach as simply trying to divide the sources of economic fluctuations into two broad categories: disruptions to production and disruptions to spending, especially on final goods.
Keeping this division in mind, during the credit expansion, the capital structure will tend to lengthen, as there is additional investment in the very early stages of production. However, at the same time, there is a drive toward overconsumption (Salerno 2012), as low interest rates make real saving unattractive. In the words of Garrison (2001, 72),
At some point in the process … entrepreneurs encounter resource scarcities that are more constraining than was implied by the pattern of wages, prices, and interest rates that characterized the early phase of the boom…. The bidding for increasingly scarce resources and the accompanying increased demands for credit put upward pressure on the interest rate.
In brief, the crisis in Austrian business cycle theory has traits that resemble a supply shock. First, resource scarcity leads to a disruption in production. Second, as in the Guerrieri et al. (2020) models, where supply shocks dominate, an increase in interest rates accompanies the crisis.
One additional trait of the Austrian business cycle is the potential for secondary effects that feel very much like a Keynes-style “demand shock.” In his review of John Maynard Keynes’s 1930 A Treatise on Money, Friedrich Hayek suggested the possibility of a “secondary deflation” in response to the reallocation process that happens amid the Austrian crisis:
[T]he very fact that processes of investment have been begun but have become unprofitable as a result of the rise in the price of the factors and must, therefore, be discontinued, is, of itself, a sufficient cause to produce a decrease of general activity and employment (in short, a depression)…. The decrease in consumption comes only as a result of unemployment in the heavy industries…. I do not deny that, during this process, a tendency towards deflation will regularly arise; this will be particularly the case when the crisis leads to frequent failures. (Hayek 1931, 42, 44)
Put in slightly different terms, the collapse of those sectors where malinvestments were concentrated leads to an unemployment wave, which creates a decrease in the demand for consumer goods, and frequent failures (which seem to resemble exit cascades) promote a more severe decline by creating deflationary pressures in credit markets. From Hayek’s description, the deflationary pressures are likely caused by the failures of fractional reserve banks, which lead to a collapse in the money supply. Building on Hayek, Garrison (2001, 75) describes it so: “[S]elf-reversing changes in the capital structure give way to a self-aggravating downward spiral in both income and spending.” He then explains that an increase in liquidity preference—driven by the recognition of the high levels of risk in the midst of an economic crisis—would be a likely result of the situation. There is a subtle difference between Hayek and Garrison. In Garrison’s analysis, bank failures are not required for this secondary spiral to occur. Instead, an increase in the demand for money, which may keep prices from rising or lead them to fall, suffices. Salerno (2012) provides additional reasons for the perception of higher risks in the crisis, pointing out that during the bust, entrepreneurs see that the economic calculation that they believed served them well in the past has failed. This failure leads to a loss of confidence in their own forecasts and in economic calculation itself. In the words of Salerno (2012, 37), these psychological phenomena “are a rational response to the calculational chaos.” Fleshing out some of the conditions that lead to these downward spirals, Huerta de Soto (2012, 453) notes that secondary depressions are most likely when “wages are inflexible, hiring conditions very rigid, union power great, and governments succumb to the temptation of protectionism.”
The overlap between Keynesian supply shocks and the Austrian secondary deflation or secondary depression is multifaceted. First, both phenomena involve a fundamentally supply-side restriction that began in one sector and leads to demand-side effects in other sectors, specifically through changes in spending behavior, and especially in consumption spending. Second, neither of these phenomena is a logical necessity—it is at least possible that the conditions may not be right for them to occur. Although the set of conditions that lead to a secondary depression posited by Hayek (1931), Garrison (2001), Salerno (2012), and Huerta de Soto (2012) do not exactly align with the parametric conditions described by Guerrieri et al. (2020), there is significant conceptual overlap. For example, in Guerrieri et al. (2020), rigid wages and interest rates mean that the demand shock would appear in the form of unemployment.
However, Keynesian supply shocks and Austrian secondary depressions do have somewhat different causes. The underlying malinvestment and resulting intertemporal discoordination in the capital structure is a specific phenomenon suggested by Austrian business cycle theory. Meanwhile, Guerrieri et al. (2020) are largely agnostic about what causes the initial supply shock, their motivating story being an entirely policy-driven initial shock. (Since their model omits capital, they certainly would not be able to capture the process described by Austrian business cycle theory.) The Austrian explanation, then, is more comprehensive, but Guerrieri et al. (2020) can provide a possible explanation for the link between the initial crisis and the broader effects in the secondary depression. Another difference between the two approaches is the view of time. The Austrian theory sees the events as playing out across time, while Guerrieri et al. (2020) compress time so that the initial supply shock and resulting demand shock all happen in the same period. This comes from the mathematical structure they use, which sees the economy as moving from one equilibrium state to another, with less attention paid to the transition between equilibria. Disaggregating not just across sectors but across time will be an important element in identifying the existence of ripple effects between sectors in the historical illustrations that follow.
APPLICATION TO 2006–09 FINANCIAL CRISIS As an illustration of how a shock in one sector can create broader effects, as would be the case in a Keynesian supply shock or an Austrian secondary depression, consider the timing of employment effects during the 2007–09 financial crisis. This crisis was caused by excessively low interest rates, which led to too many resources being directed toward investment in housing construction. As interest rates rose, housing values collapsed and the financial sector experienced related difficulties. Eventually, these difficulties spread to the economy on a broader scale. To see this effect, consider the level of employment in construction and in financial activities compared to all other sectors in the United States.
Figure 1. Employment in construction and finance, January 2005 to October 2010
Source: Data from the US Bureau of Labor Statistics Current Employment Survey. In figure 1, each series is normalized so that the employment level at the peak for that series in this time frame takes a value of 1. The data reveals that the peak employment for financial activities was in October 2006. Construction followed soon after, in December 2006. The other sectors as a group, however, did not peak until April 2008—about eighteen months after the peak in financial activities employment. (The National Bureau of Economic Research [NBER] recognizes December 2007 as the official beginning of this recession—at which point employment in the initiating sectors had already fallen by about 5 percent, though employment in other sectors was stable or slightly rising.) As additional evidence of the primary importance of Financial Activities and Construction, one may note that by December 2010, four full years after the employment peak, financial activities shed about 15 percent of the jobs it had at its peak, while construction shed nearly 30 percent, and these series were still declining. The Producer Price Index (PPI) for building material and supplies dealers is also consistent with the Keynesian supply shock theory over this period. From January 2006 to the peak PPI in September 2006, there was an increase of over 10 percent in this PPI—consistent with the idea that builders were bidding against one another for limited resources, as Hayek describes, and as would be expected in a sector-specific supply shock. These prices fell back as the construction sector neared its employment peak. So, it seems that production was limited on the supply side in construction and that this led, a few months later, to a decline in employment in that sector—which later created secondary demand-side effects, as seen in employment data for indirectly affected sectors.
APPLICATION TO THE 2020 COVID-19 CRISIS Guerrieri et al. (2020) present their theory in connection with the COVID-19-related shutdowns. Interestingly, the data does a significantly poorer job of showing a “Keynesian supply shock” in this period than during the financial crisis that happened a decade earlier.
Figure 2. Employment in various sectors during the COVID-19 shutdowns, January–June 2020
Source: Data from the US Bureau of Labor Statistics Current Employment Survey. Figure 2 shows the normalized employment from the Current Employment Survey from the US Bureau of Labor Statistics, divided by supersector. In this case, every supersector peaked in February 2020, with just one exception: trade, transportation, and utilities—which had a January employment figure 0.0007 percent higher than in February. (Meanwhile, for retail trade specifically, the peak is in February, as you find in other sectors.) Also, nearly every sector had its lowest post-peak level of employment in April, after a small decline in March. The exceptions were employment in mining/logging, information, and government, which continued to decline into at least May (mining/logging descended through August [not shown]). Every other sector bounced back. This certainly does not match what one would expect from the Keynesian supply shock theory: immediate impacts in the sectors most directly affected by the shutdowns (leisure and hospitality, which includes restaurants and hotels, for example, is a clear candidate for “first round” effects) and then secondary effects in those sectors less directly impacted (accounting—a part of professional business services sector—is specifically mentioned in Guerrieri et al. [2020] as a field that would experience these effects). Although the most severe employment effects were seen in the more directly affected sectors (leisure and hospitality as well as “other services”), there does not appear to be even a one-month lag between the employment collapse in the most impacted sectors and other industries. Those that experienced the longest delays (such as mining/logging), moreover, seem, intuitively, to be unlikely victims of a demand-side ripple effect, as it seems implausible that layoffs in leisure and hospitality led them to decrease their demand for ores and lumber. Because the data shows no clear demand-side ripples, the COVID-19 shutdowns are more consistent with a traditional supply shock.
Before dismissing the Keynesian supply shock concept as unimportant in the COVID-19 shutdowns, three observations are worth making. First, as previously noted, Guerrieri et al. (2020) compress time. Naturally, this is not realistic if a single day is considered a period. However, since employment data has a monthly frequency, the question is whether the fundamental supply-side shock could have demand-side employment effects within a month, so that the available data would appear to be affected simultaneously. The answer here is not obvious, but the possibility cannot be entirely ruled out. Second, the full effects of this crisis are not yet known. In the previous financial crisis, there was an eighteen-month delay between the peak in the initiating sectors and peak in other sectors. It may be that enough time to observe the secondary depression simply has not passed. However, the data at this point does not seem consistent with the Keynesian supply shock theory. Third, policymakers have been attacking the COVID-19 crisis with aggressive stimulus measures, both fiscal and monetary. This stimulus may have managed to cover up much of the secondary depression. In short, while the data does not show a clear Keynesian supply shock, this shock could be occurring but simply not have appeared in the available data.
POLICY IMPLICATIONS Throughout their paper, Guerrieri et al. (2020) suggest the importance of expansionary monetary policy to ameliorate the employment problems created by lockdown policies. Exactly how expansionary monetary policy would have to be depends on the specific version of their model. In many cases, all that is required to achieve the first-best outcome—that is, as mild a recession as possible, given that the direct effect of the lockdowns cannot be avoided—is to allow real interest rates to fall to the natural rate (defined on the basis of time preference and the marginal utility of consumption across time periods). However, there are some cases when a strongly expansionary monetary policy that pushes the real interest rate below the natural rate is recommended—for example, when the loss of an employer-employee “match” would create a loss in productivity after the shutdown ends. In addition, Guerrieri et al. (2020) emphasize the importance of social insurance—redistributing lost income from those who do not experience job losses to those who do experience job losses—as ameliorating some of the broader losses in well-being from shutdowns by moving markets closer to being “complete.”
The policy front is where the similarity between Keynesian supply shocks and Austrian secondary depressions has its greatest practical value. Based on the original framework that inspired the idea of the Keynesian supply shock—a framework in which capital goods are entirely absent and social insurance is assumed not to create moral hazards—expansionary monetary policy and social insurance appear to be clearly beneficial. However, considering Austrian insights, the misguided nature of these policy prescriptions—particularly advocating expansionary monetary policy—becomes clear. In the words of Hayek (1931, 44), “Any attempt to combat the crisis by credit expansion will, therefore, not only be merely the treatment of symptoms as causes, but may also prolong the depression by delaying the inevitable real adjustment.” This would especially be the case in the more typical business cycles that experience “Keynesian supply shock” effects (such as the financial crisis). Plus, as argued by Suntum (forthcoming), money that is created through credit markets tends to push interest rates below the natural rate, which would ensure the Hayekian effects described above.
If we confine the idea of Keynesian supply shocks to the COVID-19 lockdowns, then the expansionary monetary policy and social insurance programs suggested by Guerrieri et al. (2020) are less objectionable. In this case, the bust was induced by the shutdown of those sectors deemed nonessential rather than by a recognition of a misallocation of resources. As a result, expansionary monetary policy will not prolong a necessary reallocation, and its ability to create a new Austrian-style boom is limited by continuing lockdown policies. However, if expansionary policy continues after the lockdowns are lifted, then the normal Austrian analysis regarding credit expansion would become relevant. With social insurance programs, a significant concern is that such programs disincentivize work. However, given COVID-19-related public health concerns, reducing contact between employees and coworkers may have benefits that normally would not exist. Although this does not imply that the benefits of these policies outweigh the costs, it is worth recognizing that there are potential benefits that would not apply in normal circumstances. In short, the policies that Guerrieri et al. (2020) suggest for offsetting the secondary demand shock have more benefits and fewer costs than normal in the presence of COVID-19-related health concerns and lockdowns. However, the employment data examined does not clearly point to any significant secondary demand-side effects so far. In the absence of secondary demand-side effects, policies to offset them are clearly unnecessary. In short, the COVID-19 crisis seems to be primarily a traditional supply shock, but policy induced. If this is the case, as long as the damage done is not irreversible, the economy will recover when supply is freed of its policy-induced constraints—and this has already been observed in the very fast bounce back in both employment and GDP as restrictions in most states were partially loosened shortly after the initial lockdown.
However, there is good evidence of “Keynesian supply shock” effects during the previous financial crisis. Disruptions in the financial and construction sectors were clearly followed by ripples (albeit limited) in the rest of the economy. But in this kind of situation, it is socially beneficial to allow employer-employee matches in the bloated sectors to be broken, so that workers can allocate their skills elsewhere. Interventions aimed at keeping these matches in place—such as a paycheck protection program or expansionary monetary policy—will have the effect that Hayek emphasized: simply delaying the necessary adjustments. Similarly, resource use will improve if, along with labor, capital is reallocated out of bloated sectors and into sectors that were not stimulated by the previous credit expansion. And, certainly, during a typical economic downturn, there are no significant public health concerns that might lead to changes in the optimal approach by making minimizing unnecessary contact a desirable goal.
In the end, the policy prescriptions suggested by Guerrieri et al. (2020) are least objectionable in the COVID-19 crisis—where the evidence that the underlying theory applies is relatively weak. On the other hand, in the 2007–09 financial crisis, there is much stronger evidence that the underlying theory applies, but the policy prescriptions suggested were implemented (at least in part), and likely created negative consequences by prolonging the misallocations that led to the crisis in the first place.
CONCLUSIONS AND AREAS FOR FURTHER RESEARCH This paper takes the new concept of Keynesian supply shocks presented by Guerrieri et al. (2020)—inspired by the containment policies used to combat COVID-19—and connects it with the old concept of secondary deflation presented by Hayek (1931). The connection between these two concepts provides a bridge between Austrian business cycle theory and more mainstream approaches to macroeconomic fluctuations, and the data surrounding the 2007–09 financial crisis, which has proven to be a great demonstration of Austrian business cycle theory, is consistent with elements of the Keynesian supply shock/secondary deflation progression (much more so than the data from the 2020 COVID-19 crisis). The similarity between these phenomena allows for Austrian business cycle theorists to provide insights into the policy prescriptions that are suggested by those advocating the idea of Keynesian supply shocks—ideas such as expansionary monetary policy to preserve job matches, which is particularly undesirable given the necessity of reallocating malinvested capital.
One question that this paper raises is how well this perspective could help explain other business cycles across time. Both the Keynesian supply shock and Austrian secondary deflation approaches suggest that the standard Keynesian interpretation of a demand-driven business cycle may simply be describing a secondary effect, while the primary effect is fundamentally a supply-side disruption. The Keynesian supply shock framework also confirms the benefit of disaggregating data—and specifically employment data—by sector or industry to help uncover the true story of any crisis.
The data presented here also raises questions about how to interpret the economic fluctuations of 2020. Do they have a particularly “Austrian” nature? For example, how can an Austrian approach to capital structure help aid understanding of the impacts of the shutdown? Are policies that would create problems in a typical business cycle—such as those designed to preserve employer-employee matches—potentially beneficial in the presence of other policies creating their own set of problems—such as the forced temporary shutdowns of “nonessential” businesses? Are the COVID-19 shutdowns a case where the middle-of-the-road policy would lead toward socialism, or is there a logical stopping point, so that this slope is not as slippery as it might seem? Although the current economic situation does not seem to justify such policies, in an age where interventionism is the dominant view among policymakers, it would be best to have answers ready when their time comes.
Abstract: This paper endeavors to develop a modern theoretical underpinning of Friedrich August von Hayek’s business-cycle theory as published during the Great Depression in his book Prices and Production. According to Hayek, economic cycles are caused by monetary shocks, which distort the relative-price schedule across economic sectors. Possible consequences of these price distortions, which are also called “Cantillon effects,” include malinvestment and an unsustainable production structure, which sooner or later has to be corrected by a recession. It turns out that this type of economic fluctuation can be condensed into a simple two-sector overlapping generations model.
JEL Classification: B12, B22, B53, E14, E32, E52
Nils Herger (nils.herger@szgerzensee.ch) is lecturer at the Study Center Gerzensee of the Swiss National Bank and lecturer at the University of Bern. This paper has benefited from valuable comments and suggestions by Dirk Niepelt and an anonymous referee. The usual disclaimer applies.
INTRODUCTION A collapse in aggregate demand, which is followed by sluggish price adjustments, is probably the most widely cited explanation for recurrent boom-and-bust cycles in economic activity. The corresponding business cycle theory was, of course, popularized amid the mass unemployment of the Great Depression through Keynes’s landmark General Theory, published in 1936. In a nutshell, Keynes argued that shortfalls between aggregate demand and aggregate supply, which are typically associated with a reluctance to invest and a savings glut, are neither automatically, nor quickly reversed through changes in interest rates, prices, or wages (see, e.g., De Vroey 2016, 3ff.; Niehans 1990, 349ff.). In particular, the price adjustment mechanism can malfunction, because wage reductions or interest rate cuts can lead to deflation, which lures entrepreneurs into postponing investment and, hence, aggravates the downturn. Low levels of interest rates and deflationary policies cannot restore the “animal spirits” of entrepreneurs, to employ Keynes’s famous catchphrase (1936). Rather, to revive aggregate demand by breaking the vicious cycle that depresses investment, a fiscal stimulus is arguably warranted. In contrast to low interest rates through monetary policy, demand activation through fiscal policy is thought to exhibit powerful multiplier effects on investment and consumption and, therefore, has turned into the preferred Keynesian tool for stabilizing macroeconomic activity.
However, according to another contemporary interpretation, the Great Depression was an unavoidable reaction to the overexpansion of the 1920s (De Vroey 2016, 4; Kindleberger 1973, 130). The corresponding theoretical case was probably most prominently made by Friedrich August von Hayek in his book Prices and Production, which was published in 1931 and was based on four lectures delivered at the London School of Economics (LSE). In brief, Hayek argued that recessions are necessary evils following any boom which has led to overinvestment and a distorted capital and production structure. More specifically, such distortions in prices and production are thought to be initiated by money and credit expansions. Insofar as newly created money and credit flow via specific sectors into the economy, Hayek suggested that a loose monetary policy is typically associated with a distorted relative-price schedule. Manipulated price signals misguide, in turn, individual consumption and investment decisions and, at least in some sectors, produce an overaccumulation of capital. Such overexpansion leads to an unsustainable production structure. Sooner or later, redundant parts of the capital stock have to be liquidated, which can arguably only occur through a recession with dampened consumption and divestment. According to this narrative, any form of macroeconomic stabilization policy is futile. In particular, fiscal and monetary stimuli cannot prevent, but only postpone, the inevitable downturn and, possibly, expose the capital and production structure to even greater distortions. In particular, manipulation of monetary variables does no good, insofar as such interventions preserve the mistaken price signals that lie at the origin of boom-and-bust cycles.
Major elements of Keynesian economics, such as the role of inflexible prices and wages, or the temporary lack of market clearing between savings and investment, had already been highlighted by classical economists (see Sowell 1974, chap. 2; Niehans 1990, 54, 59, 103, 349; De Vroey 2011). In a similar vein, the business cycle theory proposed by Hayek drew heavily on earlier contributions to economic theory. Above all, it drew on a detailed account of how money enters the economy via specific sectors, and how corresponding booms could entail relative-price effects on real economic activity, that had already been published by the French economist Richard Cantillon in 1755. In particular, Cantillon observed that new discoveries of monetary metal, such as gold, could initially affect economic activity and prices closely related to the mining sector but are only gradually felt in, e.g., the agricultural sector. This implies that, in relative terms, agricultural prices will temporarily change. These types of relative-price distortions give, in turn, rise to real economic effects (see, e.g., Bordo 1983, 242; Thornton 2006).
Even though Keynes’s and Hayek’s views on economic fluctuations are both rooted in classical economics and partially overlap by, e.g., focusing on movements in savings and investment as the main components of the business cycle, there are also conceptual differences. In particular, Keynes (1936) analysed economic relationships between purely aggregate, or macroeconomic, variables including the overall price and wage level, identified destabilizing downward spirals between prices and economic activity, and advocated fiscal policy as stabilisation tool for an inherently unstable macroeconomic system. Furthermore, in his view, recessions can be avoided when vicious cycles leading to unnecessarily low economic activity are interrupted through adequate economic-policy interventions. Conversely, Hayek (1931) suggested that relative prices and the composition of consumption, investment, and capital matter more than their aggregate values, highlighted the role of individual savings and investment decisions for economic analysis, suggested that flexible price adjustments act as automatic stabilisers, and interpreted recessions as unavoidable consequences of instable money-and-credit policies, which undermine an inherently stable macroeconomic system.
Keynes (1936) presented a theory without integrating the various economic relationships into a complete model (Patinkin 1990). As the narrative of the General Theory often remains vague, and lends itself to various interpretations, it was followed by a voluminous literature trying to explain what Keynes really meant (see De Vroey 2016, 23ff.). Keynesianism has entered economic textbooks mainly through the IS-LM model of Hicks (1938), whose interpretation was recognized by Keynes (1973, 80) himself (see De Vroey and Hoover 2004). Since this triumphant advance in the late 1930s, this type of the Keynesian theory has led to the New Keynesian model (NKM), which to this day provides probably the most popular framework to analyze short-term interrelationships between economic policy, inflation, and unemployment (see, e.g., Galí, 2015).
Conversely, the type of economic-cycle theory advocated by Cantillon or Hayek has only received sporadic attention, mainly after a credit-boom has ended in a severe recession (see, e.g., Cochran 2010, 2011). From a theoretical point of view, the historical dominance of Keynes (1936) is perhaps surprising, because modern macroeconomic theory has taken up distinct elements of Hayek (1931), such as the insistence on developing macroeconomic theory from individual decision-making, or the recognition that policy interventions can cause, rather than improve, bad economic outcomes (see, e.g., Scheide 1986). However, similar to the original work of Keynes, the largely verbal exposé of Hayek does not always lend itself to a straightforward interpretation. This problem is aggravated by the fact that there have hitherto been virtually no theoretical models to clarify the postulated relationships between relative-price signals, the capital and production structure, and fluctuations in consumption and investment. Possibly the only exception is Beaudry, Galizia, and Portier (2016), who have employed a modern monetary model with search and matching frictions to show that a liquidation of overaccumulated capital can indeed cause high levels of unemployment, which cannot always be corrected via Keynesian fiscal policy.
Against this background, this article endeavors to contribute to the literature by developing a simple theoretical framework that captures some of the key elements of the cycle theory put forward in Prices and Production. For this task, a model is warranted where individuals as producers and/or consumers decide to save and invest in different forms of capital, where money flows via specific sectors into the economy such that policy shocks can alter the relative-price schedule between these sectors and hence change the consumption, investment, and production structure. Furthermore, the model should be dynamic, such that cyclical adjustments toward its long-term equilibrium can potentially arise. This article suggests that these elements can be found in overlapping generations (OLG) models—one of the main frameworks of modern macroeconomics (see, e.g., Romer 2019, 76ff.)—with two sectors (see Galor 1992). Following Cantillon’s (1755) scenario, the sectors in the model presented herein will be a gold-mining sector that produces monetary metal that provides a store value and an agricultural sector that produces consumption goods (perishable food). Within this context, Cantillon effects will simply originate in extraordinary discoveries of gold, which change the relative prices between the sectors. As will be shown with this two-sector OLG model, relative-price effects can indeed generate cycles in economic activity.
In acknowledgement of the early origin of some elements put forward in Prices and Production, the simple two-sector OLG model shall be referred to as the Cantillon-Hayek cycle (CHC) theory, but this label should not disguise its obvious overlap with the Austrian business cycle (ABC) theory, as discussed by, e.g., Cochran (2010, 2011) in light of the global financial crisis (see also Hébert 1985).Furthermore, Prychitko (2010) and Mulligan (2013) suggest that the ABC theory overlaps, in turn, with Minsky’s financial instability hypothesis. A key difference, however, is that the ABC theory typically emphasizes the destabilizing effects of monetary policy and credit creation in a fractional reserve banking system (see, e.g., Hébert, 1985, 275ff.; Cochran, 2011, 271–72). In contradistinction, in the model developed in this study the role of the money and banking sector is ignored.
This article is organized as follows: The first section reviews the CHC theory and provides an overview of the relevant literature. Section 2 develops the simple model reflecting the principal elements of this theory. The final section provides some concluding remarks.
I. THE CANTILLON-HAYEK CYCLE THEORY IN WORDS As Hayek (1931, chap. 1) himself emphasized, he did not develop his economic cycle theory from scratch, but drew heavily on earlier economic thought. Among other contributions, he refers to the quantity equation in David Hume’s 1752 Political Discourses, the relative-price effects in Cantillon’s 1755 Essai Sur La Nature Du Commerce En Général, the impact of the quantity of money upon interest rates and prices as discussed in Henry Thornton’s 1802 “Paper Credit of Great Britain,” and the role of the natural rate of interest for economic stability in Knut Wicksell’s 1898 Geldzins und Güterpreise (see also Niehans 1990, 24ff., 53ff., 105ff., 247ff.). Furthermore, reflecting Hayek’s personal and intellectual origin in Vienna, stepping-stones for his cycle theory were laid by fellow Austrian economists, especially Ludwig von Mises with his 1912 in-depth verbal discussion of the functions, forms, and the value of money, including its interrelationships with credit and relative prices. In particular, Mises’s (1912, part 2, chap. 6) analysis of the role of relative-price effects as regards current “consumption goods” and “investment goods,” e.g., those that are not destined for current consumption, is singled out by Hayek (1931, 25–26) as an important ingredient in his cycle theory.The terminology for goods that are destined for current consumption and future consumption is not uniform between Mises and Hayek. Mises (1912, part 2, chap. 6, section 1) refers to “present goods” (“gegenwärtige Güter”) and “future goods” (“künftige Güter”), while Hayek (1931, 25, 36–37) refers to “consumers’ goods” and “producers’ goods.” However, many of these ideas were only introduced to an English-speaking audience through Hayek’s 1931 Prices and Production.Elements of Prices and Production first appeared in German in Hayek (1928a, 1928b, 929a, 1929b). This book makes a contribution in its own right by integrating the abovementioned strands of the literature to argue that relative-price effects can alter the production structure such that money and credit booms generate economic fluctuations (see, e.g., Ekelund and Hébert 1997, 515–16). During the 1930s, partially as a response to points of criticism raised by Keynes and his disciples, Hayek elaborated on his cycle theory (see, e.g., Wapshott 2012). Landmark contributions toward this debate include “Monetary Theory and the Trade Cycle” (1933), “Profits, Interest, and Investment” (1939), and “The Pure Theory of Capital” (1941). Finally, when high inflation had turned into a major problem, Hayek (1979) revisited his cycle theory, but focused on the role of price stability (see White 1999; Cochran 2011).
The quantity theory serves as the point of departure for the theoretical analysis in Prices and Production. It is indeed uncontroversial that, in a fully monetized economy and over any given period, the aggregate value of payments is by definition equivalent to the aggregate value of production, which implies an intimate relationship between the money stock, the overall velocity of money, the general price level, and total production. However, whereas Keynes (1936, chap. 20, section 3) found the quantity equation wanting because it can break down during periods with deficient aggregate demand, Hayek (1931, 5ff.) argued that relationships between aggregate money, overall inflation, and total production disguise the crucial role of disaggregate prices and the structure of production in a multisector economy. Heterogenous developments at the individual level are, arguably, crucial for understanding the disturbing effects of economic cycles. The distinction between an aggregate and a disaggregate theory cuts into fundamental methodological issues as regards the appropriate level of economic analysis and the role of individuals as decision-makers. For example, Hayek (1931, 4–5) lambasted a naïve interpretation of the quantity theory as an attempt “to establish direct causal connections between the total quantity of money, the general level of all prices and, perhaps, also the total amount of production.”
He goes on to suggest that this is inadequate because
none of these magnitudes as such ever exert an influence on the decision of individuals; yet it is on the assumption of a knowledge of the decision of individuals that the main propositions of … economic theory are based…. In fact, neither aggregates nor averages do act upon one another, and it will never be possible to establish necessary connections of cause and effect between them as we can between individual phenomena, individual prices, etc. I would even go so far as to assert that, from the very nature of economic theory, averages can never form a link in its reasoning. (Hayek, 1931, 4–5)
This paragraph reflects the key tenets of Austrian economics that decisions are subjective and are made by individuals who differ in motives, knowledge, or expectations (see, e.g., Ekelund and Hébert 1997, 508ff.).In contrast, in the preface to the French edition of The General Theory, Keynes (1942) seems to argue that there is no major difference between modeling individual decisions and relationships between macroeconomic aggregates:I regard the price level as a whole as being determined in precisely the same way as individual prices; that is to say, under the influence of supply and demand. Technical conditions, the level of wages, the extent of unused capacity of plant and labour, and the state of markets and competition determine the supply conditions of individual products and of products as a whole. The decisions of entrepreneurs, which provide the incomes of individual producers and the decisions of those individuals as to the disposition of such incomes determine the demand conditions. And prices—both individual prices and the price-level—emerge as the resultant of these two factors.
Launching an economic analysis from the individual level can have far-reaching implications. Above all, under a disaggregate view, shocks to, e.g., money and credit do not directly affect overall inflation, but impact first and foremost specific prices (including certain wages and interest rates). Furthermore, unless the economy involves completely homogenous individuals, these shocks are typically transmitted to prices and production in a heterogeneous manner. In particular, regardless of whether we contemplate an increase in the amount of currency through monetary policy interventions or privately created deposits by commercial banks, the added money and credit flows via specific sectors into the economy and is typically spent by select individuals on certain classes of goods, services, and assets. Taken together, individual heterogeneity in a disaggregated economy implies that monetary shocks can give rise to so-called relative-price effects. The view that across a range of products nominal prices will change at uneven rates, and that the associated relative changes entail real economic effects, can be traced back to Cantillon (1755, part 2, chap. 6). In particular, Cantillon described how new discoveries of monetary metal within a purely metallic currency system initially benefit the gold miners, whereas the new bullion and coins trickle only gradually through to other sectors, such as agriculture, and hence alter relative food prices in the process (see also Niehans 1990, 31–33).Cantillon effects can be invoked against the view that the quantity theory necessarily implies the neutrality of money when prices are flexible. In particular, Cantillon (1755, part 2, chap. 7) argued that money is not per se neutral with respect to (flexible) prices, becausemoney does not affect equally all the kinds of products and merchandise, proportionally to the quantity of money, unless what is added continues in the same circulation as the money before, that is to say unless those who offer in the market one ounce of silver be the same and only ones who now offer two ounces when the amount of money in circulation is doubled in quantity. (qtd. in Thornton 2006, 48) Bearing witness to their historical origin, the relative-price effects from monetary shocks are also called “Cantillon effects” (see, e.g., Bordo 1983, 242; Thornton 2006, 47ff.).
Cantillon effects are obviously not restricted to a society of miners and farmers. For example, Malthus (1811) said of an increasing circulation of paper money (or notes) that relative-price effects can arise between individuals who currently produce and consume and individuals who only consume. In his words:
If a thousand millions of notes were added to the circulation, and distributed to the various classes of society exactly in the same proportions as before, neither the capital of the country, nor the facility of borrowing, would be in the slightest degree increased. But, on every fresh issue of notes, … a larger proportion falls into the hands of those who consume and produce, and a smaller proportion into the hands of those who only consume. And as we have always considered capital as that portion of the national accumulations and annual produce, which is at the command of those who mean to employ it with a view to reproduction, we are bound to acknowledge that an increased issue of notes tends to increase the national capital. (Malthus 1811, 364–65)
Why would relative-price effects matter for aggregate economic fluctuations? In this regard, Hayek (1931, chap. 2, chap. 3) observes that prices not only fulfill a compensation function in individual transactions, but also act as an information and coordination device by indicating economic scarcity and sending signals organizing economic activity. Hence, manipulated prices can misguide individual decisions and, in turn, distort the capital and production structure of the economy. Above all, misleading money and credit policies have an immediate effect on interest rates and investment decisions. These manipulations are not innocuous: they lead to an unsustainable production structure, which makes an economy more and more prone to a crisis. In particular, an indiscriminate creation of money and credit tends to push interest rates below their equilibrium level—or what Wicksell (1898) called the natural rate. Low levels of interest rates can foster, in turn, investment in relatively capital-intensive sectors (Hayek 1931, 86–87; 37ff.). Borrowing heavily from Austrian capital theory—and employing the corresponding terminology—Hayek (1931) devotes chapter 2 to describing how money and credit booms can guide economic activity toward a “longer,” “more roundabout,” or “more capitalistic” production structure. In modern terminology, this probably refers to investments in goods whose returns come in the relatively distant future (see Steele, 1992, 478ff.). When contemplating present value calculations, it is indeed conceivable that, e.g., low interest rates increase the range of profitable investment projects (see Steele 1992, 479).
Typically, a shift toward a more capitalistic production structure—in terms of an increasing output of “investment goods”—comes at the expense of sectors whose output consists of current “consumption goods” (Hayek 1931, 88). Insofar as the money and credit boom is an exogenous event, individuals are essentially forced to live with a lower amount of current consumption goods to “set aside” the savings that are needed to support the investment boom. It is again noteworthy that this doctrine of “forced savings” can be traced back to classical writings, e.g., Malthus (1811, 364) and Thornton (1802, 263) (see also Hayek 1932; Sowell 1974, 65). However, Hayek connected the forced savings doctrine with the abovementioned distinction between individuals who produce and consume (or entrepreneurs), and individuals who only consume. In particular, as regards the reduction in the available amount of consumption goods when moving toward a more capitalistic production structure, he observed that
this sacrifice is not voluntary…. It is made by the consumers in general who, because of the increased competition from the entrepreneurs who have received the additional money, are forced to forgo part of what they used to consume. It comes about not because they want to consume less, but because they get less goods for their money income. There can be no doubt that, if their money receipts should rise again, they would immediately attempt to expand consumption to the usual proportion. (Hayek 1931, 57)
In other words, relative-price effects can generate a production structure with overinvestment and underconsumption. However, when the money and credit expansion slows down, or is even reversed, the misallocation between investment and consumption goods will be corrected (Hayek, 1931, 89ff.). Arguably, this correction is necessarily associated with an economic downturn (Hayek 1931, 92–93; Hayek 1979, 25). Taken together, a distorted production structure is unsustainable, as
the machinery of capitalistic production will function smoothly only so long as we are satisfied to consume no more than that part of our total wealth which under the existing organisation of production is destined for current consumption. Every increase in consumption, if it is not to disturb production, requires previous new saving…. If the increase of production is to be maintained continuously, it is necessary that the amount of intermediate products in all stages is proportionally increased…. The impression that the already existing capital structure would enable us to increase production almost indefinitely is a deception. (Hayek 1931, 95)
The policy conclusions of the CHC theory are diametrically opposed to the Keynesian belief in the merits of government intervention to stabilize the economy. According to Hayek, policies such as monetary expansions and fiscal stimuli are not the solution but rather the cause of economic instability. To recapitulate, manipulated price and interest rate signals interfere with individual investment and consumption plans. Misguided individual consumption and investment decisions bestow an economy with a distorted production and capital structure. Insofar as a money-and-credit boom is typically associated with an overexpansion, which has eventually to be corrected by a liquidation of capital, fiscal or monetary stimuli cannot prevent a downturn from happening (Hayek 1931, 97ff.). Rather, such government interventions are problematic, because they preserve, or even aggravate, the distorted price signals and, thereby, tend to prolong and/or deepen the recession (see also Beaudry, Galizia, and Portier 2018, 119–20). Economic downturns are necessary evils, and recoveries require a restoration of interest rate and price signals, based on which investments in a sustainable production and capital structure can made (Hayek 1931, 99).
According to the CHC theory, the only way to dampen economic fluctuations is to stabilize money and credit conditions (Hayek 1931, 97ff; Hayek 1939, 73–82; Hayek 1979, 4).Hence, like monetarism, the CHC theory interprets cycles as monetary phenomena. However, the monetary distortions occurring at the disaggregate level in Hayek (1931) stand in sharp contrast to the overarching role attributed to monetary aggregates in, e.g., Friedman and Schwartz (1963). In this way, Cantillon effects and distorted production structures do not occur in the first place and unnecessary large swings in investment and savings are avoided. However, it is not entirely clear what stable monetary conditions concretely mean. Hayek (1931, chap. 4) refers to upholding the convertibility of the currency at the established mint pars of the gold standard, but after the transition to a pure fiat currency during the 1970s resulted in high inflation, Hayek (1979) turned to price stability as the key criterion (see White 1999; Cochran 2011).
II. MORE THAN WORDS: A SIMPLE TWO-SECTOR MODEL OF THE CANTILLON-HAYEK CYCLE THEORY 2.1. Background For a modern economist who has read the purely verbal exposés of Cantillon (1755) or Hayek (1931), it is probably not always clear how exactly relative-price effects can alter the capital and production structure such that boom-and-bust cycles arise. What determines the long-term equilibrium with respect to which concepts such as “overinvestment” are defined? Can an economic boom indeed be followed by cyclical adjustments toward that equilibrium and, if so, what assumptions are required to obtain this result? These and other questions can only be answered by means of a theoretical model.
To capture the key ideas of the CHC theory, a microfounded model is warranted that lends itself to introducing a money-like asset, encompasses several forms of capital, includes separate sectors producing investment and consumption goods, allows for relative-price changes that give rise to Cantillon effects, and distinguishes between individuals who primarily produce and individuals who primarily consume. Furthermore, the different sectors and individuals should be more or less directly affected by monetary expansions, and the model should be dynamic in order to determine whether the adjustment toward some long-term equilibrium occurs in a cyclical manner. Arguably, these elements can be found in two-sector overlapping generations (OLG) models pioneered by Galor (1992) and discussed in Azariadis (1993, 258–67), Farmer (1997), Farmer and Wendner (2003), and Cremers (2006). In particular, a standard (one-sector) OLG model lends itself to the introduction of a medium of exchange à la Samuelson (1958), accounts for the allocation between consumption and investment, encompasses different groups of individuals (“generations”), and embodies the concept of the steady state as long-term equilibrium. Furthermore, when an OLG model encompasses two sectors, the relative price of investment and consumption goods associated with these sectors can potentially change.
What is particularly relevant in the context of this study is Farmer and Wendner’s (2003) suggestion that two-sector OLG models can exhibit cyclical adjustment patterns after a policy shock. However, Farmer and Wendner (2003), as well as Galor (1992), focus on the role of economic growth and Cremers (2006) on the role of dynamic inefficiency in a two-sector economy. Consequently, these papers neglect issues related to business cycles, which Hayek (1931) emphasized.
Against this background, this section endeavors to develop a simple model to show how relative-price effects can, under certain parameter sets, give rise to economic cycles in a two-sector OLG environment. To keep the model simple and tractable, capital will be the only production factor (there is no labor market), and the effects of time discounting, population growth, and technological progress are ignored. Finally, specific production functions are imposed.Thanks to these simplifications, it is possible to avoid such issues as multiple equilibria, which can arise in an OLG environment and have been used to study business cycles (see, e.g., Grandmont 1985). Cycles associated with multiple equilibria are typically not attributed to shocks or variations in economic policy and, hence, do not reflect the CHC theory. In particular, the two-sector OLG model with a Cobb-Douglas-Leontief technology (Farmer 1997; Farmer and Wendner 2003) will be extended to a constant elasticity of substitution (CES)–Leontief economy. In the current context, the flexibility of the CES function is needed in order to compare the different reactions of capital inputs to relative-price changes across a range of production technologies. Of course, Cantillon’s agricultural and gold-mining sectors hardly account for the roles of monetary policy in the manipulation of interest rates or of the commercial banking sector in creating unstable credit booms, as emphasized by the ABC theory. Also, the CES-Leontief economy only hints at the lengthening of the production structure, as discussed by Hayek (1931, chap. 2). Nevertheless, the two-sector OLG model reflects a standard framework in modern macroeconomics, and can apparently capture the link between relative-price manipulations between different economic sectors, changes in the capital structure, and cyclical adjustments toward a new equilibrium.
2.2. Notation and Basic Assumptions The present OLG model encompasses two forms of capital. Variables, e.g., physical and land capital, pertaining to these forms, are represented by superscripts i and j. There are two economic sectors. Variables pertaining to these sectors are denoted by superscripts a and g. Subscript t refers to time periods.
The a sector is like agriculture in Cantillon’s (1755, part 2, chap. 6) example. In particular, in each period t, this sector employs both forms of capital, e.g., and , to produce a nondurable consumption good, .
The g sector employs both forms of capital, e.g., and , to produce a pure investment good, , which cannot be consumed. In concrete terms, the g sector is like gold mining in Cantillon’s (1755, part 2, chap. 6) example.
Although the two forms of capital are not sector specific, they differ insofar as some forms of capital are endowed and others can be produced. In particular, there is a fixed endowment of j-form capital that does not depreciate (e.g., constant land capital). To simplify the model, this endowment is assumed to be kj=2. It is also assumed that j-form capital is perfectly mobile and is allocated between the sectors according to
(1)
Conversely, it is assumed that i-form capital is perfectly immobile between the sectors. To simplify the analysis, the endowment of i-form capital in the a-sector is normalized to one, that is, . However, i-form capital in the g-sector is assumed to depreciate fully at the end of period t, but can be augmented through the production of investment goods (). Hence, the corresponding capital accumulation function equals
(2)
Prices pertaining to goods produced in the a sector and the g sector are denoted by, respectively, and .
Relative price: the relative price between a sector (consumption) and g sector (investment) goods is defined as
(3)
With relative prices, such as pt, one price can be chosen as numéraire. It is here assumed that =1.
Note that the relative price pt will be required to express values in the same unit. Where necessary, prices will be converted into a sector units.
Remark 1 (relative-price effects): fluctuations of relative prices (modeled by equation [3]) are at the heart of the CHC theory, as they capture the Cantillon effects that are supposed to induce boom-and-bust cycles (see section 1). In particular, such relative-price effects can originate in a shock to, or manipulation of, the current g sector price, i.e., the numéraire. For example, an increase of , which implies an increase in pt, signals that goods in the g sector (i.e., gold) have become relatively more expensive.
A representative individual enters the economy at time t=0,1,2,… and exits at t+1. As there is no population growth, variables coincide with their per capita values. However, during period t, individuals own the fixed stock of j-form capital and are pure producers of investment goods and consumption goods . During period t+1, individuals are pure consumers of an amount denoted by ct+1.
Remark 2 (heterogenous population): the overlapping structure just mentioned implies that during each period t, the population consists of a group of (pure) producers, and a group of (pure) consumers.
2.3. Assumptions about the Production Functions The production of consumption goods is assumed to obey a simple Leontief function with both forms of capital as factor inputs. With =1 (see section 2.2), that function is
(4)
The rigid production structure of Leontief functions simplifies the analysis by limiting the output of consumption goods in the a sector to one unit. Furthermore, Leontief technologies typically require a fixed combination of factor inputs (here only capital) to optimally produce a given amount of output. Specifically, to produce the maximal amount of consumption goods with function (4), the optimal capital input in the a sector would be fixed to 1, that is,
(5)
It is assumed that investment goods in the g sector are produced by means of a constant elasticity of substitution (CES) function given by
(6)
Within the current context, this production function is useful, because it encompasses a range of technologies to produce investment goods, which are typically the main channel through which fluctuations occur in the CHC theory (see section 1). Specifically, υ reflects whether or not the production of is subject to scale economies, where υ=1 yields constant returns and 0<υ<1 decreasing returns to scale.Increasing returns to scale would arise in (6), if 1 < υ. However, because capital is here the only production factor, this case seems implausible. Furthermore, ρ is a substitution parameter, which determines the CES, denoted by σ, between the inputs of different forms of capital via σ=1/(1-ρ). When 0<ρ<1, there is a high elasticity of substitution (e.g., σ>1). When ρ<0, the CES is σ<1, which implies that the capital structure that produces is rather rigid. Special cases arise when ρ approaches 1 (and σ=∞), which yields a linear; when ρ approaches 0 (and σ=1), which yields a Cobb-Douglas; and when ρ=-∞ (and σ=0), which yields a Leontief production function.See, e.g., Varian (1992, 13–20).
Under a high degree of substitutability between the different forms of capital, as measured by ρ, it will be more likely that relative-price effects will give rise to a distorted production structure and, in turn, economic cycles. Conversely, with a Leontief technology, e.g., ρ=-∞, the two forms of capital are perfect complements and typically enter (6) in fixed proportions. In this scenario, relative-price changes do not affect the capital structure in the g sector at all and are hence unlikely to initiate economic cycles.
2.4. The Saving and Consumption Decisions In the current two-sector OLG model, the saving decision is trivial.
Remark 3 (forced savings): Any individual is initially a pure producer and becomes a pure consumer during the next period (see section 2.2). This assumption reflects the concept of “forced savings,” as individuals have no other option but to save their income to satisfy future consumption (which shall enter into the standard utility function, u(ct)). They cannot shift consumption across time or postpone productive activity.
Consumption is subject to the budget constraint. Specifically, as a pure producer during period t, an individual generates income from producing investment goods, , and consumption goods, . Savings, denoted by st, are given by the difference between the current output and expenditures for buying i-form capital in the g sector at price pt from current pure consumers. Hence, the budget constraint of the pure producer during period t equals
(7)
where pt harmonizes price units.
At the aggregate level, which encompasses the producer and consumer during period t, savings are determined by the difference between output (of investment and consumption goods) and consumption, that is,
(8)
Because consumption goods are nondurable (e.g., perishable food), they cannot be stored. Hence, in each period, the market-clearing condition equates consumption ct with the output of consumption goods:
(9)
Inserting (9) into (8) yields
(10)
which reflects the usual aggregate equivalence between investment, which is valued at the relative price, and savings. Inserting (10) back into (7) yields
(11)
An interpretation of (11) is that i-form capital in the g sector, which is produced from past investment goods () according to (2), encapsulates the option to buy current consumption goods at relative price (pt). The values , pt, and concurring with such a transaction are necessarily determined through bargaining between the consumer and the producer. To pin down these values, assume that the pure consumer can make the pure producer a take-it-or-leave-it offer. It is well known that under this bargaining arrangement, the pure consumer can extract all the gains from trade (see, e.g., Nosal and Rocheteau 2011, 61ff.). In the current model, this implies that the consumer will demand the maximum output of to maximize his utility, u(ct), with =ct (see (9)). Because there is a one-unit endowment of i-form capital in the a sector, the maximum output of consumption goods in (4) equals =1. Furthermore, according to (5), a one-to-one capital input is required to optimally produce =1. Taken together, we have:
(12)
For the sake of simplicity, it is henceforth assumed that the conditions hold that stabilize the output of consumption goods as well as the corresponding capital inputs at one unit. This concurs with the CHC theory insofar as cycles in economic activity are primarily attributed to movements in the investment goods sector.
2.5. Capital Allocation and Production Structures of Different Lengths Because i-form capital is immobile, its allocation is not guided by an intersectoral arbitrage condition. Conversely, producers can freely allocate j-form capital between the sectors. On capital markets with perfect intersectoral mobility (see section 2.2), arbitrage transactions equalize the marginal effect of j-form capital upon the revenue to produce investment goods in the g sector, denoted by , and consumption goods in the a sector, denoted by ; that is,
(13)
Recall from section 2.2 that j-form capital is owned by the pure producers and, thus, not subject to a rental price. Therefore, the revenue in the a sector is simply given by =. With the Leontief technology of (4), the output of consumption goods equals
(14)
The properties of (14)—especially its marginal product of capital—depend on how the actual combination of capital compares with its optimal input. As long as (e.g., agricultural land) is the limiting production factor, (14) implies that
(15)
The g sector revenue is given by =/pt, where pt is needed to harmonize price units. By substituting the production function (6) for and employing (13) and (15), a consolidated production function for investment goods that only depends on pt is derived (see appendix A) and is given as
(16)
According to (16), when υ-ρ>0, a higher value of pt (which implies that the relative g sector price has increased) leads to a larger output of . When the returns to scale effect of υ in the production function (6) exceeds the substitution effect of ρ, an increase in the relative g sector price expands the output of investment goods. Conversely, when υ-ρ in the denominator of the exponent of (16) is negative, the substitution away from produced capital in the g sector dominates, and an increase in pt reduces the output of .
In any case, as determines the capital stock () according to (2), changes in pt affect period t+1, the period when the current producer has become a pure consumer. Furthermore, capital is a variable in the g sector production function (6) of the future producer. Hence, although the g sector does not produce a consumable good, the investment good () can be used as a potential medium of exchange for future claims on consumption goods (c(t+1)). Taken together, in the spirit of Samuelson (1958), as long as individuals expect a positive future g sector price, the corresponding output can be valuable, even when investment goods never enter the utility function (see also Sargent and Ljungqvist 2012, 326ff.). However, rather than contemplating a given endowment of fiat money, in this model the medium of exchange has to be reproduced during each period.
Remark 4 (different production structures): the production structures of the a and g sectors differ. In particular, using the terminology of Hayek (1931, 32ff.), the g sector has a “long” structure in the sense of producing investment goods, which provide a way to satisfy future consumption. Conversely, the production structure of the a sector is “short” in the sense of employing current capital to produce current (nondurable) consumption goods.Because depreciates completely at the end of each period t, the current model cannot fully account for the concept of a "lengthening of the production process." Furthermore, as investment goods merely provide a medium to transfer value to the next period, they cannot generate an increase of productivity by "roundabout methods of production."
2.6. Capital and Relative-Price Dynamics and the Steady State Because the output of consumption goods in the a sector is fixed by (12), the dynamics of the current two-sector model are governed by the production of investment goods, which depends primarily on the evolution of i-form capital in the g sector. Let the initial value be given by and the initial relative price by p0. Jointly, the capital accumulation function of (2); the link between relative prices, consumption, and capital of (11); the stable output of consumption goods of (12); and the consolidated production function of (16) yield
(17)
Taken together, the interaction between capital, , and relative prices, pt, through (11) and (16) lies at the heart of the dynamics of the current two-sector OLG model. Indeed, below it will be shown that, depending on the parameter set, (17) can give rise to cyclical dynamics. However, before turning to the dynamic properties of (17), its long-term equilibrium is defined in terms of the steady state values for and pt ( and ) in proposition 1.
Proposition 1 (steady state): equation (17) exhibits a nontrivial steady state of 0 < , given as
(18)
The corresponding steady state value for pt is given as
(19)
(See appendix B for proofs.)
The steady states 0 < and 0 < occur when 0 < υ.
2.7. Converging Cycles Can the current two-sector OLG model generate boom-and-bust-cycles as postulated by the CHC theory? The answer depends on the dynamic properties of (17), which determine the development in the g sector. In particular, the dynamic behavior of relative prices (pt) follow from (11) and (12), and that of the production of investment goods in the g sector from (16).
To solve the nonlinear first-order dynamic equation of (17), the first-order Taylor approximation is derived at the steady-state value of (18) (see appendix C), which yields
(20)
Depending on whether the term υ/(υ - ρ) of (20) is positive or negative, and whether or not this term has an absolute value that is greater or smaller than 1, the adjustment path of can be smooth or cyclical as well as convergent or explosive (see, e.g., Azariadis 1993, 33ff.; Chiang 1984, 505ff.). Typically, a set of parameters with -1 < υ/(υ - ρ) < 0 is warranted to obtain the convergent cycles postulated by the CHC theory. Proposition 2 clarifies when this scenario arises.
Proposition 2 (stable cyclical adjustments): in the two-sector OLG model underpinning the dynamic equation (17), i-form capital () moves in cycles toward the steady state of when
0 ≤ υ < ρ ≤ 1.
When , the corresponding cycles are convergent (e.g., nonexplosive; see appendix C for proofs).
Hence, stable cycles arise only under certain parameter sets. Above all, the substitution parameter (ρ) and economies of scale (υ) of production function (6) for investment goods matter. Figure 1 depicts the different dynamic behavior across the permissible parameter values of -∞ < ρ ≤ 1 and 0 < υ ≤ 1. In particular, the gray area highlights combinations of ρ and υ giving rise to cyclical dynamics and the hatched area combinations resulting in convergent (nonexplosive) dynamics.
Figure 1. Dynamic Properties of (17) with Different Values of ρ and υ
Proposition 2 and figure 1 have established that follows a cyclical adjustment path when the substitution parameter is positive and larger than the returns to scale parameter of the g sector production function (6). This result is, perhaps, intuitive, because the high substitutability between the two forms of capital for the production of investment goods () implies that these structures can react markedly to relative-price changes (i.e., the Cantillon effects are quite strong). Furthermore, when the substitution effect is larger than the returns to scale effect, according to discussion around (16), an increase in pt reduces the output of and, in turn, .This type of price-quantity interaction has been widely documented for the cobweb model (also known as the “hog cycle”). For a textbook discussion of the cobweb model, see Chiang (1984, 561–65). This provides the basis for a cyclical interaction between prices and capital output.When the stability condition υ < ρ/2 is violated, the interaction between and produces nonconvergent cycles. Conversely, noncyclical adjustments necessarily arise when ρ ≤ 0, e.g., when capital inputs are rather complementary.Again, a noncyclical adjustment can occur in a convergent or nonconvergent manner (see figure 1).
Figure 2 illustrates the main result by showing numerical examples for a (stable) cyclical and a noncyclical adjustment of pt, , and to a shock to relative prices in period t = 1. In particular, a positive shock to pt is considered, meaning that the relative g sector price increases (see remark 1). When the different forms of capital are highly substitutable, as in example 1 with ρ = 0.8, this relative-price shock decreases the current output of investment goods () according to (16) and, subsequently, according to (2). As a reaction to this development, future relative prices decline and subsequent cycles between capital and relative prices arise. Conversely, when lowering the substitution parameter to ρ = –0.8 in example 2, there are no cycles, because the capital structure in the g sector is rather rigid, and the initial increase in pt is followed by a smooth regression to the original level.
Figure 2. Examples of a Cyclical and Noncyclical Adjustment
SUMMARY AND CONCLUSION This paper suggests that the cycle theory described verbally by Friedrich August von Hayek—and in a rudimentary form much earlier by Richard Cantillon—can be expressed through a simple overlapping generations model. In particular, when two sectors are introduced into the OLG model, it is possible for economic shocks to alter the relative prices of goods associated with these sectors. This can lead to a reorganization of the production structure and subsequent boom-and-bust cycles. Hopefully, presenting the Cantillon-Hayek theory using a modern macroeconomic model clarifies the underlying narrative for audiences that are perhaps unfamiliar with the original verbal discussions and helps uncover the different answers to seminal questions in business cycle research when compared with the Keynesian theory.
The Cantillon-Hayek cycle theory offers vastly different answers to enduring questions about the nature of business cycles, such as the disturbances that cause fluctuations in economic activity. According to the Keynesian view, demand shocks are paramount. Conversely, in the Cantillon-Hayek theory, economic fluctuations originate in excessive monetary expansion that distorts the price schedule and misdirects investment toward capital-intensive sectors. This leads to an overaccumulation of certain forms of capital, which must eventually be undone through a recession. Furthermore, economic expansions and recessions typically persist for some period of time. Hence, the question of what causes this persistence arises. Whereas Keynesians emphasize the role of price stickiness, in the Cantillon-Hayek theory, cycles are not immediately eliminated due to the delays in reorganizing the capital stock, which implies that booms and busts can become entrenched. Finally, why can nominal variables, such as money, have real effects? To explain this, Keynesians invoke sticky prices. By contrast, even when individual prices are fully flexible, the Cantillon-Hayek theory recognizes that money can flow via specific sectors into the economy. Hence, prices of goods closely associated with the economic sectors through which nominal expansions occur can change relative to other prices. Temporarily, such “Cantillon effects” can have real economic consequences.
Jeff Deist: You recently completed a series of articles for the Mises Institute, which we will publish in book form, on how money works today. Why is it important for average people to understand the mechanics of the plumbing of central and commercial banks?
Bob Murphy: There’s two main reasons. First, it’s intrinsically interesting. That’s why I went into economics. Just like the average person should know the basics about physics and chemistry and Darwin’s theory of evolution, likewise, the average person needs to know: How does money work, how do banks work? Just the raw basics of it because it’s an important part of modern society, even premodern society, in terms of money. But beyond that, because central banks certainly since 2008 and even more so in the wake of the pandemic in 2020 have done lots of things that I believe are setting the world up for a series of major financial crises, and the average person needs to know about this.
JD: Considering the monetary and fiscal machinations engaged in by governments since the pandemic, it’s as though we lost any sense of what money is. It seems unlimited. People on Twitter tell us money is just information, or energy in a system.
BM: I do know what you’re saying. On the one hand, I can’t bristle too much when outsiders, people like Eric Weinstein, come forward and they say the economists have just botched it. I get why they’re saying it, because the economists have done such a poor job. It’s hard for me to say hey, stay in your lane, leave money to the economists. But, on the other hand, you’re right. We shouldn’t jump to the conclusion that the older-school economists and the ones in the Austrian tradition don’t know anything and that there’s no point in reading them. There are lots of fallacies that intelligent people who are not conversant with the economics literature might fall prey to, just like if you go into philosophy, there are lots of detours, and you would do well to take a basic course in philosophy to avoid fallacies that plagued people centuries ago. Likewise with money, there are lots of ways you can go down the wrong path, and some of these bright people who are spouting off on Twitter are just going over stuff that was demolished by Mises in 1912. They’re just repeating those fallacies and it’s because they never heard of it before.
JD: To be fair, the average Joe or Jane might well say money is just this made-up thing government tells us to use.
BM: Exactly, and it’s interesting because there is this sense in which money is a social convention, but it’s not merely a social convention. Just like spoken language is a social convention in a sense but that doesn’t mean words can just mean whatever you want. Money is a complex topic and it is easy to think of money incorrectly and certainly to then endorse government policies that would be disastrous because you don’t really understand exactly what money is or how it functions.
JD: We’ve heard two words ad nauseam over the past sixteen months: stimulus and liquidity. One is fiscal, one is monetary. Executives, Treasury officials, legislatures, and central bankers all throwing everything but the kitchen sink at the problem. Are fiscal and monetary policy effectively merging?
BM: I think you’re right that part of what’s been happening is the traditional divide between fiscal and monetary actions has been blurred. For example, during the Obama administration (this is back when this was shocking) there were four years in a row in which the federal deficit was higher than a trillion dollars. And that was also roughly when the Federal Reserve, implementing its independent monetary policy, with no concern about the budget needs of the government, was engaged in these rounds of QE (quantitative easing). And at the time, I didn’t think that was a coincidence, just like now I don’t think it’s a coincidence that the federal government is running massive deficits right when the Fed keeps adding to its balance sheet and buying Treasurys. I don’t think that’s a coincidence.
So yes, there is this merging. Then you’ve got MMT (modern monetary theory), for example, which quite explicitly just consolidates everything. They say that when the federal government runs a deficit and buys fighter jets, the Treasury instructs the Fed to mark up the checking account balances of Northrop Grumman or Lockheed Martin, or whoever makes them. I think that’s wrong. There are still some legal issues involved, and technically the Treasury can’t just spend whatever it wants and tell the Fed, “Mark up the checking account.” Legally speaking, that’s not how it works. But you’re right, conceptually that’s the way a lot of people, even with PhDs in economics, are starting to talk about it, so it is blending together.
There are some senses in which that approach is probably correct: like I said, it was naïve for mainstream economists to act as if what the Bernanke Fed did during the Obama years was purely because they were targeting CPI (Consumer Price Index) and doing it not because they knew, the feds are issuing this much debt; if we don’t want interest rates going up on Treasurys, we have to buy a bunch of them. So, it is merging, but still, conceptually, the old-school distinctions are important if people want to understand that, for example, a government that’s in a regime of hard money can still borrow money, just like corporations or households can go borrow money and that’s not per se inflationary, whereas in the modern system, yes, if the Fed or the central bank in general is monetizing the debt, that is inflationary. It’s important to get cause and effect distinct.
JD: Give us your quintessentially fair and objective description of MMT, along with your critique.
BM: What’s funny is I’ve actually formally debated Warren Mosler. If you jump into YouTube and look at the comments, they’ll say, “Oh, Murphy agrees MMT is correct, he just doesn’t like it.” It’s a very seductive approach they have where they’re casting themselves as saying, “Look, we’re not passing judgment, we’re just saying this is modern monetary, this is the way the modern financial banking system, government money system, works, take it or leave it, and you need to know this.” But at the same time, I don’t know of any MMT proponents who want the US government to return to its constitutional duties. It seems that the MMT sort of neutral, positive as opposed to normative description of how the world works almost always goes hand in hand with prescriptions for a massive expansion in government entitlements and other types of spending programs, intervention and healthcare, because they think they’ve shown we don’t need to worry about debt.
And, just to circle back, what do they do? They’re saying, unlike private sector individuals or corporations who have to use the money but are not sovereign issuers, the monetary authorities, the US government or the Japanese government, they have monetary sovereignty. They can issue their own currency. They don’t have to pledge to redeem it in some other currency. It’s not tied to anything.
After 1971, the US dollar is not redeemable in anything. It just is what it is, it’s its own commodity unto itself, there’s no actual constraint on the US government spending more money. And so they say, if we’re talking about if we should have Medicare for all, stop saying, “How are we going to pay for it?” I think that’s the fundamental point of the MMT crowd and I’m not putting words in their mouths. Stephanie Kelton, one of the major proponents right now, that’s how she talks. And so then you say, “Okay, there’s a sense in which that’s correct, but there’s also a sense in which that’s extremely dangerous and misleading.”
So yes, it is true, if the federal government wants to fund another moon shot, wants to put a base on Mars, wants to guarantee everybody’s healthcare and that’s going to cost $20 trillion in current prices, they could go ahead and just create that money. There’s nothing legally stopping them. But to me that’s a very dangerous thing to tell the public, because it leads them to believe they can do it without any bad consequences, when in fact, I would argue, doing that’s going to raise the dollar prices of goods and services. You’re not creating extra real resources just by creating dollars. Under a gold standard, for example, everybody would agree, it’s too expensive, it’s not worth it to try to build a Mars base any time soon. By freeing the Federal Reserve from the fetters of gold, you don’t all of a sudden give us better technology. You don’t all of a sudden make more spaceships available or bases that are half built on Mars. It’s the same use of scarce resources to achieve that outcome regardless of the financing mechanism. That’s what I would say, and the MMT people will give a nod occasionally too and say, “We know prices could rise. We’re just saying that’s the constraint.” But still, that’s very misleading.
The analogy I’ve used often is to say: Imagine a couple, they’re over the kitchen table and they’re scratching their heads and say, man, these finances. We want to pay for the kids’ college, but my job only pays this, and we just can’t afford that vacation next month. And then, what if somebody gave them the insight and said, “No, stop thinking like that. You could put on a ski mask and go hold up a 7-Eleven.” And then the couple says, “Wouldn’t we go to jail or be shot by the store?” The third party would then say, “Yes, that’s true, we’re not denying that, but let’s stop talking about it in terms of we can’t afford things. Instead, the issue is do we want to go on the vacation more than we want to risk going to prison?” That’s really the tradeoff you face, and there’s a sense in which that third party giving the advice to the couple is correct, but they haven’t really helped the conversation any by making the correction that financing the vacation’s not the issue here. It’s do you want to risk going to prison if you hold up the convenience store?
That’s what the MMT people bring to the table when they say, “Let’s stop saying we can’t afford Medicare or is the public willing to tolerate higher taxes, because we can just print the money.” You’re not helping anything and in fact, you’re just dangerously leading people to believe this is some financing mechanism that actually you would never want to endorse.
JD: In the MMT conception, when Uncle Sam creates debt—public debt—that debt is private wealth.
BM: Great point and you’re right, that’s another pillar of MMT, at least about how they talk to the public and flip around your thinking about everything you’ve heard about government finance.
JD: Like deficits.
BM: Yes. That’s another sacred cow they’ll tackle. And let me be clear, I understand why so many people have become enamored with MMT, and especially Stephanie Kelton’s latest book, The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy, is provocative as well. She’s a funny writer, and I can see how someone who’s willing to go down that path can read her book and say, “This is great.” Specifically what they’ll say is, “Don’t listen to these budget hawks, who say let’s stop passing the buck to our grandkids. If you think about it from an accounting perspective, the only way the private sector can accumulate net financial assets is if the government goes deeper into debt.”
The way they’re thinking about it is: if my pension fund accumulates corporate bonds, my pension fund might have more assets, but then that means the corporation that issues those bonds now has that extra liability, so on net, those members of the private sector just cancel out. They’re saying the only way the private sector as a whole can have claims on some entity that doesn’t internally cancel out is if the entity is a non–private sector group like, oh, the US federal government. If the private sector accumulates Treasurys, stop looking at it as, Uncle Sam’s deeper in debt, how are we going to pay for this as taxpayers? Instead, look at it as, we now have many more assets, look at all these extra Treasurys we have. That’s the argument they use and I think there’s a sense in which it’s correct in terms of the accounting.
I actually think it’s not right because you could have equity. If someone starts a corporation and then people have shares of that and it’s a productive enterprise, your share price doesn’t correspond to somebody’s debit somewhere. Even on its own terms, that’s actually not correct. But even if it were correct, it still is misleading because you could just as well say, “The way that the world minus the Mises Institute gains net financial assets is the Mises Institute goes deeper into debt.” That’s also true in terms of the accounting. It’s misleading, especially when it comes to government bonds: the way we as a private sector get paid what we’re owed on those “net financial assets” is the government points guns at us, takes money, and then hands it right back to us and says, “Here’s the payment on your Treasurys, thank you.” There’s no sense in which we should view that as some asset that’s exogenous that makes the private sector wealthy.
JD: I’ll play devil’s advocate. To be fair to MMTers, in 2020 the US federal government borrowed about half of what it spent and the sky didn’t fall. And Professor Stephanie Kelton, the current face of MMT, is not nearly as odious as Krugman or some of our Keynesian friends.
BM: Right.
JD: If MMTers tend to hold left-wing political views and support big government, their retort would be that Austrians tend toward libertarian views—so our theory is just as “political.” And the idea that a sovereign issuer of currency can spend unlimited money, well you can see the enormous seductive appeal.
BM: Yes, Austrian economists stress that Austrian economics is positive, it’s not normative, and yet, in practice, very few people study Austrian economics and say, “Yes, now that I know how the business cycle works...” that’s possible. So, point well taken there. I also agree with you that Warren Mosler is a charming guy. When I debated him years ago, we were chatting before the debate and he was so charming and friendly that I realized I needed to step away, otherwise I was going to be a softie in this debate. The MMTers can say, “But regarding the issue of you right-wingers, not just the Austrians, but the Glenn Beck and Bill O’Reilly types of the world were warning since 2008, look what the Federal Reserve is doing and the dollar is going to crash. Some people were even using terms like hyperinflation, talking about the Weimar Republic and wheelbarrows. None of that happened, so how long are you guys going to continue to be wrong, talking like that?” I would say, on the one hand, yes, that’s a reason people should be careful and not throw out wild predictions, and I myself have made some predictions that turned out wrong and then I have to bear the brunt of that.
But, beyond that, if we are in an environment where the demand to hold money goes up, prices would have come down. Part of the problem is that people who had savings, they would have seen those savings having much more purchasing power than they do today. It’s really an issue of it’s a counterfactual relative to what otherwise would have happened. It still is true that by the Fed creating such and such more dollars, the purchasing power of the dollar is lower than it otherwise would have been, even though yes, measured in absolute terms, gasoline is not $20 a gallon right now. It’s also true too that by the Fed creating this money, it’s redirecting resources in the political channels.
Let’s use an analogy. If you found out your neighbor down the street was using his color printer to print out authentic-looking $100 bills, he’s been doing it for years, and that’s how he has nice cars. That’s how he goes on these vacations he’s telling you about. That’s how he can afford to dress impeccably. It would be silly for him to exonerate himself and say, “Did the economy crash, is gasoline $20? No, so stop blaming me; you can see nothing bad happened.” That wouldn’t be the issue, right? Can you understand why in that context, it’s the same thing economically? Just as I wouldn’t want my neighbor to have that ability, I don’t want Federal Reserve officials to have that ability either.
JD: Let’s talk about interest rates. Since 2008 and this period of extraordinary monetary policy, really since the Greenspan era, interest rates have been driven relentlessly lower. We’re now in a bizarro world where maybe a third of European sovereign debt is nominally negative. Nobody can make any money on a CD or simple savings account. What the hell is going on with interest rates?
BM: This is an area too where the economists have egg on their faces and I don’t just mean Austrian or conservative ones. Even Paul Krugman. They were matter- of-factly explaining: Nominal interest rates can’t go below zero because people would just switch to holding cash and that’s why once the Fed’s policy rate gets close to zero, we need to switch to other unconventional things or have deficit spending. The negative nominal interest rates shocked a lot of economists across the spectrum, because they had been teaching their students for years that it was literally impossible and then once it happened, the economists had to scratch around and say. That’s because in large institutions, to actually hold that much cash, you’d have to insure it and what are you going to do, put it in a safe deposit box? Once the impossible happens, economists are good at after the fact explaining why it happened and criticizing people who have, in their view, silly explanations.
But, it’s not that I saw negative nominal interest rates coming. I certainly think central banks have a lot to do with it, so to the people who argue to the contrary and say, “No, the Fed and ECB (European Central Bank) are just following the market down,” well, in one sense I want to say: then you should have no objection to the Fed and the ECB just liquidating their holdings and selling their assets, right? Because according to you, that’s not going to make interest rates go up. And usually they say, “No, that would make interest rates go up and that would crash everything. That would be a crazy policy to have such a restriction.” Usually when you push that they will admit yes, central banks and their policies have had something to do with lower interest rates. One of the points of QE was to lower long-term rates, because they were saying short-term rates went down to zero. Basically, that wasn’t enough, so now the Fed needs to intervene and try to push down long-term rates in order to stimulate spending, from a Keynesian perspective. Even the people pushing these things do admit, either explicitly or implicitly, the low nominal interest rates at least have something to do with massive central bank action.
Partly why it’s happened is people are so panicked. That right now, there’s such uncertainty and desire for perceived safety that people are willing to just sit on earning basically nothing with government debt. Especially if it’s from the US or the Japanese government, that’s perceived as being very safe in terms of they’re not going to default on the bond, even if they’re earning nothing or even if they’re earning slightly negative— even in nominal terms. But that’s not a natural evolution of capital. That’s not because the Chinese are saving so much. That’s because there have been these crazy business cycle swings, which, in the Austrian perspective, is because of massive central bank intervention. Ultimately, I would say it’s the central banks and their policies that have led us to this position, directly because they’re monetizing debt and pushing down interest rates and indirectly because they’ve caused the massive uncertainty that’s causing people to be so fearful that they want to have huge holdings in ostensibly safe assets.
JD: You mentioned some economists who say “Central banks don’t much matter; this trend was happening anyway.” But people like former Fed chair (now Treasury secretary) Janet Yellen also warn there are limits to monetary policy. The term is pushing on a string. There’s only so much monetary policy can do. What have these ultralow interest rates done for us?
BM: I agree that the ultralow interest rates have not done anything benign or good for us, that they present a problem. Somebody from a Yellen perspective or a Paul Krugman, what they mean when they talk like that is to say, “We can go ahead and push down interest rates, like I say, down to basically 0 percent and then we can engage in QE, even, and try to raise inflationary expectations in the future.” And the reason for doing that is to lower the real interest rate. So they’re saying once nominal rates get to zero (and yeah, they actually could go slightly negative, but they couldn’t go to –10 percent in nominal terms; even money market funds would switch to hold cash), how do you lower the real interest rate? You’ve got to raise expectations of future price inflation so that in real terms even a 0 percent nominal rate translates into –10 percent.
But, they’re coming from a Keynesian perspective when they talk like that. They think what you want to do is make people want to consume or invest now and the way you do that is you lower real interest rates. That’s the framework that they’re in and as an Austrian, I would say that that’s wrong, that interest rates have a job to do. They communicate information, if you want to use that language, and it means something. If the interest rate in the market would be 4 percent and instead it’s been pushed to zero, that’s going to screw things up. It causes the boom-bust cycle. As far as Yellen, especially now that she’s Treasury secretary, what they’re trying to get at is, there’s only so much the central bank can do. Once we’ve done all that and we’ve run out of ammo, it’s up to the fiscal policy to go ahead and run big budget deficits. So again, I think that’s totally wrong, what they’re saying, but that’s what they mean, because in their framework, what you do is you lower interest rates to stimulate spending, to fill aggregate demand. They’ve lowered interest rates, all right, and we’re still in a bad economy, so you can see how from their perspective, let’s try something else, then.
JD: Maybe it’s a political deflection on her part. But conceptually, axiomatically, we know nobody would loan you $100,000 today in exchange for a payment of $90,000 two years from now. Interest rates are supposed to be positive.
BM: Right. One way of putting it is look at the extraordinary circumstances that had to exist to explain why the Bank of Japan and maybe the ECB were considering this scenario. If you keep money on deposit with us and then you pull it out, they’re going to then charge you interest retroactively. I’m making these numbers up, but if they wanted to have a –10 percent rate and you pull out half your money, then they would actually ding the remainder that you left on deposit double that, so that you’re not gaining by pulling money out of the system. I’ve seen plans in place, I think it was in Japan, to avoid precisely that. That, if we wanted, if our policy rate were to be excessively negative in nominal terms, such that everybody would switch to holding physical currency, we’re going to set things up to ding you for that, to look at what your historical balance has been over the last five years to make it so that you don’t have the incentive to do that. They are setting that up so that they can get away with doing that, and that’s partly why there’s this push to get rid of cash, because that’s ultimately the way to protect yourself. I can hold a currency and earn zero percent in nominal terms in a safe in my house and so if they can get rid of currency so it’s all electronic, then you can’t even do that. You’re right, thinking through the logic of it in normal circumstances, why wouldn’t you just hold actual money if the banking system’s paying you negative nominal rates? There is a sense of that’s crazy and it can’t be a normal outcome.
JD: As an aside, it’s pretty remarkable how Mises’s Theory of Money and Credit from 1912 has held up. If you want to understand interest rates, go read that book.
BM: As you know, a few years ago the Mises Institute commissioned me to produce a study guide for that book. I had to reread it and sort of the old joke about when I was younger my dad was an idiot and then I grew up and I realized how much smarter he had become or wise. It was the same sort of thing—I had read it in grad school, and then having read it years later to do the study guide, I realized, Mises just has offhand remarks about all sorts of things like forex speculation and derivatives markets, and things like that, calls and puts, I think. It is interesting to see how much he really was a great financial economist. He understood modern money and banking and financial markets of his day and handled them as a brilliant theorist.
JD: There’s a lot of mainstream talk today about inflation. I wonder if that’s another concept, another term, where we have lost any agreed-upon definition.
BM: Right. Mises, famously, complained about— this was like the midcentury in terms of the US—he complained to an American audience saying how it used to be in the early 1900s, that everybody knew what inflation meant, it was an expansion of the quantity of money stock and/or the credit that the banks made available. And so, inflation had the inevitable consequence that prices quoted would go up, but inflation meant—just picture inflating something—a quantity of money would be inflated. That’s where the term came from, and he said, but now, over the decades, it has been changed—and again, he’s speaking in the 1950s— what the public thinks inflation means is rising prices. And that’s unfortunate, he said, because it’s now mistaking the symptom for the cause, and you can’t fight it if what you think the thing is is actually just a symptom. He said we have this perverse situation where the people causing the inflation are posing as the people protecting the public from inflation, which is crazy.
Since 2008, with all the massive monetary inflation that we’ve seen and with the rise of the internet and financial commentary by people outside the accepted gatekeepers, there’s been a resurgence and interest in that definition. Nowadays more people understand this huge expansion of the monetary base and look at the Fed’s balance sheet, look at all this inflation, and yes, it hasn’t shown up yet in prices at the grocery store necessarily, but look at all this inflation that’s now been pumped into the system. A lot of “regular people” who are not ideological and not steeped in the Austrian school understand that sort of language, and so we’re seeing a return to that.
But you’re right, there’s not an agreement on what does inflation mean and even in terms of looking at prices, the standard definition, it’s a very narrow basket of consumer goods. What if stock prices triple? Why isn’t that considered inflation, especially if the reason they went up is because the Fed created a bunch of money? What if real estate prices go up? People have to buy houses. It’s weird distinctions that they’re making: whereas the rental price, how much you have to pay to rent an apartment, can go into the cost of living index but if the price of a regular house goes from $200,000 to $400,000, that’s not considered that the cost of living has gone up, or at least it’s not that per se. You’d have to do implicit rental prices and whatnot. It is right that there is some disagreement, but I think it’s a healthy thing. At least, because the old consensus of two decades ago was wrong, or was harmful, at least now the fact that there’s some confusion is a sign of improvement.
JD: Just the other day Jerome Powell said that there is effectively no link between M2 and inflation. It feels like the Fed is going to do this forever. They’re going to do whatever is required to maintain at least the nominal price of equity markets. They’re going to keep interest rates low forever. They’re going to have “easy” monetary policy forever. But surely this can’t last forever?
BM: To elaborate a little bit on what you were saying with Powell, the Fed, they’ve been very slippery and so, it was true, like in 2008–09, when people like me, for example, or Peter Schiff, were warning about, look at this QE program, this is crazy. This monetary inflation will lead to price inflation. And the critics would say, “No, go look at CPI. Come on, you guys are crazy.” CPI’s just doing its thing, and then CPI starts rising and they say, “The Fed’s preferred measure is the Personal Consumption Expenditure Index, or, of course, CPI, let’s strip out the volatile food and energy price,” and they keep doing these redefinitions of things. Whether you’re looking at headlines, CPI, or even core CPI or personal, depending on each one, it’s going back ten, twenty years, and it’s the highest it’s been in thirty years. And it’s way above the Fed’s own stated target—and it’s funny, the headlines say things like, “Powell Sticks to the Script on Inflation,” like they’re not saying it as a conspiracy. I’m not saying Zero Hedge, I’m saying CNBC. The way they describe it is Powell’s got his script and he knows: Right now our position is inflation’s not a big deal. And so even though, according to their own metrics, it’s finally bouncing above what they’re saying the target is, we’re not going to tighten, because we think it’s transitory.
You’re right, they’re going to keep doing this until it’s so calamitous that even they can’t pretend that this is just a temporary blip. We’ve seen used car prices up over 50 percent year over year. They’re going to be able to blame it on the pandemic and just say, “No, that’s because of supply chains.” But eventually, you keep seeing numbers like this, they’re going to have to deal with them and at least make it look like they’re tightening. But they’ve painted themselves into a corner, like you say, now, financial markets are utterly dependent on the Fed being willing to come in and buy $50 billion plus of assets per month. The Fed needs to stop doing that because even they can’t ignore the warning signs in terms of standard prices that households face, then you’re going to have another major financial crisis.
JD: It is not just banks who are dependent on low rates, but also Congress itself. If average Treasury rates rose to historical averages, say 5 to 8 percent, debt service quickly becomes the single biggest federal budget item every year.
BM: Right, exactly. At Mises University, I had a chart in my talk recently just showing the metrics of the CBO (Congressional Budget Office)—as they describe it, the nonpartisan CBO. And they’re pretty good.
JD: Yes.
BM: I said that as if it was ironic, but no, even some of them would email me about things, areas like climate change and economics, when they were doing carbon taxes. So, yes, they want to at least be fair, or at least the people who were running it the last ten years that I’ve interacted with. But they’ll have charts of the US debt as a fraction of GDP. In the forecast, I’ll show it just going up and up and up, and that’s because, number one, you have demographic shifts, in terms of Medicare and Medicaid. You also have interest rates rising just a few percentage points, back to not even historic levels, but 1980s levels, even 2005 levels—then debt would be devastating in terms of the annual cost of servicing it, because there’s so much more outstanding nominal Treasury debt now compared to ten years ago. The reason it doesn’t feel so painful is because the yields on those Treasurys have been close to zero. And, that’s why you can get away with issuing trillions more in debt. But if those numbers go up, you’re right. If the Fed were in a position to maintain sanity in terms of purchasing power and to stop the runaway spiral in price inflation they were supposed to jack interest rates up to 8 percent; that would cripple the financial integrity of the US government. They are painting themselves into a corner where my guess is they’re going to do a little bit of both—let the dollar lose a lot of its value vis-à-vis other currencies and have the federal government’s finances get really hammered where we can pay for some of the entitlements and servicing the debt and that’s about it.
JD: We worry a lot about what Congress is doing and spending. We worry a lot about what the Fed’s doing. We worry about commercial banks responding to what the Fed’s doing. But in your forthcoming book you have an entire chapter devoted to shadow banking— carried out by nonbank lenders. What is shadow banking and should we be concerned about it?
BM: The term, as it suggests, is transactions happening in the shadows. These transactions, they serve the same economic function as traditional bank lending, but don’t operate through formal banks. If there’s any kind of private entity that raises capital and then goes around and funds ventures and things like that, that’s a way of ultimately linking savers and borrowers in a nexus that falls outside the traditional banking sector. Broadly speaking, that’s what shadow banking refers to.
The conventional reason, by the standard establishment types, they’re saying, After the 2008 crisis, we had Dodd-Frank (Dodd-Frank Wall Street Reform and Consumer Protection Act) and we can beef up the SEC (Securities and Exchange Commission). The Federal Reserve can go ahead and beef up regulations all they want, but that’s really clamping down on traditional banks. They look at investment banks, but that just pushes more people into the shadow banking sector, where we can’t regulate. So they use it as calls to have broader regulation and whatnot.
From my perspective, it is concerning because by its very nature, it’s hard to quantify this because it’s all kinds of things that don’t get reported on by the main government statisticians, and it’s hard to get data on this, but certainly those types of financing mechanisms have become more prevalent. The problem is, for example, that an institution, they owe people a bunch of money, but they’re saying, These other people owe us money. And so, those webs get pyramided on top of each other. That shows how if there’s a crisis in one area, they can all of a sudden have this domino effect elsewhere. You partly saw that in the 2008 crisis, that it wasn’t the fall in mortgages per se that caused the problem, it was the people that had put out things that would make you whole if your mortgages went down and that was even just a margin call. So, these were the chain reactions that made the mortgage-backed securities markets seize up.
That’s the concern that I have: there’s a sense in which the financial sector globally is intertwined and people are engaged in a lot more leverage, and even conventional metrics might miss some of this, and if a crisis breaks out even in one localized area, that could quickly spread, because people don’t fully realize how vulnerable the whole system is.
JD: How much off-balance-sheet debt is out there? Maybe there are trillions of dollars in exposures which don’t show up in our traditional measures of sovereign, corporate, household, or individual debt.
BM: I think that’s true. When I was doing research for the chapter you’re talking about in the book, it was surprisingly hard to pin down. I can see studies that look at this chart, but the problem was that they each had their idiosyncratic definitions as to what are we including in this metric.
JD: How much debt is in the world?
BM: If I have a $200 tab at my local bar, does that get counted? There’s lots of things like that that are more formalized, of course, but it’s ultimately how much do people think other people owe them, and there are different degrees of legality. Then who are you reporting that to? It’s not as easy to measure as how much outstanding Treasury debt is there.
What about what the federal government implicitly has promised current workers? When you retire, we owe you these benefits of social security. Well, that’s not a legally enforceable claim, but yet usually that gets counted in terms of the federal government’s liabilities, broadly considered. You’re right that there’s these different levels. Or if privately held companies have understandings with others, they could be formal contracts, but if nobody has access to that because they want to keep this secret, there could be all sorts of debt claims people hold against each other that aren’t showing up in our statistics.
And to the extent that there’s more regulation reporting requirements and there’s less privacy in the official channels, that’s made people go more underground, and especially with crypto, it’s becoming easier and easier for people to deal with each other financially in ways that do not show up in the public ledger. It’s true that these claims have grown, but by their very nature, it’s hard to quantify that. So how much? I don’t know because that’s kind of what we’re talking about; it’s in the shadows.
JD: It’s not always shadowy. Maybe the biggest nonbank lender in the United States is Quicken Loans, but we don’t think of them as nefarious. And they might seek out a political bailout from Congress if housing markets go south, but unlike commercial banks they can’t go to the Fed and get dollar reserves for their junk assets.
BM: Right.
JD: So maybe we should champion them.
BM: I use the term shadow banks just because that’s the term that’s thrown around, but you’re right. Like I said, a lot of times when you hear people discuss this, it’s from the perspective of people who don’t trust it. Unless the SEC and the Fed are involved, we can’t trust this. So, you’re right, it’s in the shadows should not be taken to mean there’s something illicit about it. I am in favor of financial transactions that are more just person to person and entity to entity and the government’s not involved. Unfortunately, though, like you said, the Fed has expanded the sorts of activities that it can dabble in, and that does mean that the bigger the sector, the more that people could argue these groups are too big to fail. Until the point at which the dollar starts really crashing, why wouldn’t the Fed come in and buy that up and rehabilitate that market?
JD: I want to finish by talking about bitcoin. You wrote Understanding Bitcoin: The Liberty Lover’s Guide to the Mechanics and Economics of Crypto-currencies in 2015. What prompted you to write that book, and have your thoughts on bitcoin changed or evolved?
BM: I want to mention my coauthor, Silas Barta. He was a person who had an early mining rig before I even understood what that term meant. He was into bitcoin and he helped in terms of the math.
JD: He’s currently filthy rich on a private island somewhere?
BM: I don’t know. I know he can pick and choose when he works, but I don’t know how much he actually held. Why I wrote the book, to answer your question, when bitcoin first came out, people were telling me about it, and I looked into it and did a lot of research. It’s a cool thing. I wasn’t into it so much at the beginning. As I got more and more into it I could see there was a group of people who knew about economic theory, monetary theory, and there was a group of people who understood public and private key encryption and Satoshi’s white paper, and there was very little overlap between those two groups. The monetary economists were talking about bitcoin in ways that were not right because the bitcoin community was saying, “No, you’re making false statements about how bitcoin works.” But then at the same time, the people who knew how bitcoin worked in terms of the mechanics of it would then say, “It’s the money right now and it’s the best currency,” and the economists would say, “No, that’s not how money works. You’re talking about money improperly.” That was the rationale for the book I wrote with Silas Barta, to give a framework. This is how bitcoin works mechanically and then in terms of how you would place this inside standard monetary theory in the Austrian tradition. This is how you would do it. I was just trying to clarify the terminology so those two groups could talk to each other and not make the other think they were idiots because they were making a basic mistake in nomenclature.
JD: Do you view bitcoin differently today? Seven years in bitcoin time is like seven hundred.
BM: Exactly. We were very careful in that book to say over and over we’re not telling you to invest and this isn’t saying it’s a good speculative asset. We are not talking about whether, measured in dollars or some other currency, bitcoin’s going to go up or down. We’re just explaining to you the mechanics of it. That was partly to make sure it wasn’t construed as investment advice, but also it was because I was more agnostic at the time.
Having seen it continue to grow, having seen massive price dips and people numerous times go, “Bitcoin’s dead, told you so,” and then it comes back and hits new highs. I now am comfortable saying in the year 2100, for example, people will still be checking the bitcoin blockchain. Some of it will be lost—people lose their private keys—and people will still know who holds it. I don’t necessarily think it will be a huge player in international commerce. It might be something akin to having big bars of gold right now, in that people know who owns them, but it’s not that those gold bars right now are the centerpiece of global transactions.
I’m not saying bitcoin is going to still be the primary cryptocurrency, but I do think people will hold it, whereas probably back when we wrote that guide I would not have been so comfortable saying that. I’ve seen enough now with the explosion of market caps and various types of cryptos to think that it is here to stay. It’s not that crypto’s going to disappear in ten years and people are going to look at that as a fad. That’s my view at the moment, and probably I’m more comfortable saying that now than I would have been back in 2015.
JD: Final question. What is the endgame? Does the US dollar get unseated in our lifetimes? How does all of this debt and monetization come to an end?
BM: I think it was Jim Rogers who said that the nineteenth century was the British century, the twentieth was the American, and the twenty-first is going to be the Chinese century, and I think that’s true. Given what they’re doing with the dollar, the only thing that’s going to make Federal Reserve officials pull back on how many dollars they’re creating is a massive crisis. Once that happens, they will be chastened, and maybe they’ll save some face, but I don’t think the dollar is going to reemerge as the global world’s reserve currency, with the prestige it had circa 1965. I don’t think that’s going to happen partly because the US’s prestige on the world stage is shrinking in many metrics and what the Fed’s been doing has been very irresponsible. It’s been coasting on its reputation.
If a South American government’s central bank had done the things the Fed has been doing, their currency would have crashed long ago. Speculators would have dumped it, saying this is reckless. The Fed gets away with it because people think, Come on, this is the Americans. They can’t be that foolish. Surely, if things start to get out of hand, they would quickly reverse course, and with what they’ve done now, that’s not going to be possible. That’s a long way of answering your question. Thirty years from now, I think the US in general is going to be a much smaller player in global affairs. There might be a basket of currencies that the IMF (International Monetary Fund) discusses, with SDRs (special drawing rights), or the World Bank, and the dollar still might be a big component of that. But in terms of is the dollar going to be viewed as the world’s reserve currency, no. In thirty years, I don’t think people will talk like that at all.
JD: Thanks very much, Bob Murphy.
BM: Thanks, Jeff.
Abstract: The new “secular stagnation hypothesis” developed by Lawrence H. Summers attempts to justify why the demand stimulus applied in the aftermath of the global financial crisis failed to revive growth in a satisfactory manner. Building on previous ideas of Keynes, Hansen, and Bernanke, Summers claims that excess savings together with feeble investment drove the natural rate of interest down to zero and advanced economies into stagnation. As the US monetary policy rate is not allowed to fall below the zero bound, Summers calls for “quantitative easing” and more expansionary fiscal policy to spur investment demand. This paper refutes Summers’s hypothesis by revealing its internal inconsistencies and presenting both theoretical arguments and empirical evidence on the long-term evolution of savings, investment, productivity, and capital stock. It also estimates the natural rate of interest following the approach of Salerno (2020), which is further refined based on Rothbard’s “pure interest rate” theory. The calculation shows that the natural interest rate did not drop to zero after the global financial crisis, but has actually remained consistently and significantly above the federal funds rate and the bank loan prime rate. This not only invalidates Summers’s central claim, but confirms once more the explanatory power of the Austrian business cycle theory in relation to the main trigger of the global financial crisis and its subsequent unfinished recovery.
JEL Classification: E43, E51, E52, E31, E32, E12, E14
Mihai Macovei (macmih_mf@yahoo.com) holds a PhD in international economics from the Academy of Economic Studies in Bucharest. He is an associated researcher at Ludwig von Mises Institute Romania and works for an international organization in Brussels, Belgium. The author is grateful for useful comments from Nikolay Gertchev and Amanda Howard.
Puzzled by the anemic growth performance in advanced economies five years after the global financial crisis (GFC) of 2007–08 and the inability of mainstream macroeconomic theories to explain it, former US Treasury secretary and Harvard professor Lawrence H. Summers (2013) expounded a new “secular stagnation hypothesis,” reviving an old Keynesian theory developed by Alvin Hansen during the Great Depression. At the core of the theory, which tries to justify government interventionist policies, lies the assumption that major structural societal changes have reduced investment demand in modern economies, whereas savings have continued increasing. This has created a “savings glut,” which has driven the equilibrium or natural real interest rate all the way down to near zero and made monetary policy largely ineffective.The natural rate of interest concept was developed by Wicksell ([1898] 1962), and although mainstream economists started using it as well, they modified its meaning, as explained below. Summers uses interchangeably the concepts of “natural,” “equilibrium,” or “neutral” rates, which he defines as “the interest rate that will prevail when the economy is at full employment and price stability” (Summers 2017). In order to combat the secular stagnation engulfing advanced economies, monetary policy would allegedly need to be recalibrated toward “quantitative easing,” and fiscal policy, in particular public investment, should be used more aggressively.
It may not be a coincidence that both Hansen and Summers released their theories precisely at times when the Keynesian theoretical framework was incapable of explaining why interventionist policies stimulating demand could not lift the economy out of recession. But instead of pouring old wine in new bottles, Summers could have usefully consulted the Austrian business cycle theory (ABCT) in order to understand the disappointing output growth following the global financial crisis. The ABCT was primarily elaborated by Austrian school economists Ludwig von Mises and Friedrich A. von Hayek and explains how excessive growth in bank credit due to artificially low interest rates set by a central bank or fractional reserve banks triggers an unsustainable boom and “malinvestments,” i.e., intertemporal misallocation of factors of production. A recession is bound to follow, because there are not enough real savings to support all the projects started in the boom. The recession liquidates the boom’s “malinvestments” and adjusts the structure of production to the economy’s new saving-investment preferences and natural interest rate. According to the ABCT, further monetary expansion via “quantitative easing” and larger fiscal stimuli, as advocated by Summers, can only prolong the gap between the loan and natural interest rates, perpetuate entrepreneurial miscalculations, and cause economic stagnation. The Keynesian supposed cure for low growth is actually its main cause.
The key point in assessing the validity of Summers’s hypothesis is the claim that chronically weak investment demand together with a “savings glut” have significantly decreased the natural interest rate to close to zero and below the market loan rate. This allegedly depresses growth and justifies “quantitative easing” and negative interest rates. After brief presentations of the new “secular stagnation hypothesis” and of Knut Wicksell’s “natural interest rate” theory in the following sections, this article explains why the main arguments underpinning Summers’s theory are flawed. Using both theoretical proof and statistical evidence on the evolution of real savings, investment, productivity, capital stock, and inflation, this article disputes Summers’s central claim that the natural rate of interest fell significantly toward zero in recent years. Going a step further, it then estimates the natural interest rate for the US economy starting from an approach devised by Joseph T. Salerno (2020), which is further refined based on Murray N. Rothbard’s “pure interest rate” theory. The latter describes how the pure rate of interest is determined in the time market and permeates the entire structure of production. The final section concludes that the refutation of the new “secular stagnation hypothesis” calls for ending the decade-long policies of stimulating demand, which have proven detrimental to reviving sound economic growth.
THE NEW “SECULAR STAGNATION HYPOTHESIS“ In the presidential address delivered at the American Economic Association in 1938, Hansen presented a new interpretation of the protracted weak recovery from the Great Depression. According to him, the US economy was suffering from “secular stagnation,” i.e., it had reached a maturity stage where savings were increasing, but investment was falling due to a decline in population growth and subdued technological progress. If the main challenge of capitalist economies in the nineteenth century had been weathering business fluctuations, the twentieth-century problem became unemployment as depressions became longer and deeper (Hansen 1939).
To remedy declining investment demand, which had theoretically fallen below the level necessary to absorb savings, and the ensuing unemployment problem, Hansen advocated more rapid technological progress and the development of new industries to replace the maturing ones by increasing investment opportunities. He also saw a role for public spending in preventing the fall in national income below a critical level. But he surprisingly cautioned, with quite strong words, against the use of public investment as a panacea for filling the saving-investment gap: “[P]ublic spending is the easiest of all recovery methods, and therein lies its danger” (Hansen 1939, 14). Carried too far, the latter would lead to higher costs and prices, prolong economic maladjustments, and displace the otherwise available flow of private investment via both taxation and borrowing. Hansen also doubted the role that the interest rate could play in spurring investment, claiming that plentiful lending at low interest would not revive stagnating real investment. Despite the fallacy of his theory, Hansen’s original view of both fiscal and monetary stimulus as a potentially dangerous and partial cure to economic stagnation seems much more reasonable than that of Summers and other modern Keynesians.Hansen (1939, 14) concludes his speech by saying that economists “will not perform their function if they fail to disclose the possible dangers which lurk in the wake of vastly enlarged governmental activities.” This is another surprising statement coming from someone often referred to as “the American Keynes.”
The secular stagnation theory fell into oblivion once the post–World War II baby boom solved at least one of Hansen’s fears, i.e., the decline in population growth. In addition, the war ended the Great Depression and new inventions like jet airplanes and computers supported the subsequent boom in productivity and output. As reality basically invalidated Hansen’s claims, his theory was laid to rest until Summers (2013) resurrected it in a speech at the International Monetary Fund (IMF). Faced with a similar challenge, i.e., a very weak recovery from the global financial crisis, despite unprecedented fiscal and monetary stimulus, Summers borrowed Hansen’s theory and refocused it on the zero lower bound, which prevents negative nominal interest rates and waters down the Keynesian monetary cure.Professor and Nobel Prize winner for his Keynesian modelling Lawrence Klein had linked secular stagnation to the idea of a negative natural rate of interest for the first time in 1947.
Noting that growth in the United States and other advanced economies had been feeble despite buoyant financial conditions during the previous fifteen years, Summers (2014a; and 2014b) hastily concludes that mature industrial economies can hardly achieve adequate growth under conditions of full employment and financial stability. He believes that this is caused by a substantial decline in the equilibrium or natural rate of interest to close to zero, reflecting a significant shift between savings and investment. The economy has supposedly undergone an “increase in private savings, and a decrease in the level of investments” which could only be balanced at full employment at “an unattainably negative level of the nominal interest rate” (Summers 2015a). According to him, the fact that nominal short-term interest rates cannot fall below zero (or some bound close to zero)Despite the fact that from 2009 to 2015 and since March 2020 the Federal Reserve System has kept the federal funds rate close to zero and the Bank of Japan and the European Central Bank have been even bolder in slashing monetary policy rates. The former has kept its key interest rate at –0.1 percent since 2016 and also added a 0 percent target for the ten-year Japanese government bond yield. The latter has operated with a 0 percent key rate and a negative rate on its deposit facility since 2014. prevents the adjustment needed to equate saving and investment at full employment (Summers 2015b).
The question is how such a chronic excess of savings over investment can exist in flexible markets, and Summers borrows Hansen’s main contributors to secular stagnation, i.e., low population growth and weak technological progress, to answer it. In addition, he points to other complementary factors. Savings have supposedly been boosted by an increase in income inequality to the benefit of people with a higher saving propensity and, most important, by a surge in global savings. Summers emphasizes the “open economy” factor and his agreement with Ben Bernanke’s “savings glut” argument.“Particularly in the 2003–07 period it is appropriate to regard Ben’s savings glut coming from abroad as an important impediment to demand in the United States. Ben and I are, I think, in agreement that it is important to think about the saving-investment balance not just for countries individually, but for the global economy“ (Summers 2015b). Emerging economies, but also advanced ones such as Japan and Germany, have supposedly accumulated excess savings for precautionary purposes and distributed them to the industrialized world, in particular the United States, by investing them in safe assets, such as US Treasurys (Summers 2015c). In turn, the United States has not been able to channel the excess savings originating abroad into domestic investment. Summers considers that the decline in the demand for debt-financed investment, reflecting the legacy of the period of excessive leverage before the Great Recession, also played a role.Although this has not prevented the U.S. nonfinancial corporate debt from soaring over the last decade while a sizeable portion of it was used for financial risk taking in share buybacks, fuelling another stock market bubble (Howard 2020). In addition, a drop in the relative price of capital goods—he gives the example of computers—has rendered investment less costly and therefore profitable companies, such as Apple and Google, will allegedly “find themselves swimming in cash and facing the challenge of what to do with a very large cash hoard” (Summers 2014a).
In order to overcome the “secular stagnation” challenge, Summers (2013 and 2015b) calls for more intrusive macroeconomic policy measures. He advocates monetary policy expansion via quantitative easing and a sizable reduction of real interest rates down to negative levels in order to match the fall in the natural rate of interest. Investment demand should also be increased, with a substantial role to be played by public investment and measures to reduce barriers to private investment. He argues in the Keynesian tradition that a substantial increase in public investment would not increase the public debt-to-GDP ratio because the investment multipliers are quite large until full employment is reached and the zero interest rate policy would suppress the debt service costs (Summers 2014a). He even calls for global action to solve the excess of savings over investment, arguing that “secular stagnation is a contagious malady” (Summers 2015c).Summers argues that Europe and Japan are exporting their secular stagnation to the U.S. by having very low equilibrium interest rates which cause capital outflows, a depreciation of their currencies, and a transfer of demand from the United States. This argument resembles John Hobson’s theory of domestic underconsumption leading to imperialistic expansion in search for new markets and investment opportunities overseas which later influenced Lenin and modern Marxists (Hobson, 1902).
It is most striking that although Summers presents some circumstantial empirical evidence in support of his hypothesis, this does not include any substantial data on the alleged global increase in real savings and collapse of investment, which are central to his argument. Moreover, in order to prove the decline in the natural rate of interest to zero, he only relies on some estimates in Laubach and Williams (2003) complemented by data on the decline in international real interest rates. Early on, a large inconsistency is evident in his treatment of interest rates. On the one hand, Summers (2015a and 2015b) claims that savings are chronically in excess of investment because nominal interest rates are constrained by the zero lower bound. On the other hand, he argues that real interest rates need to follow the decline in the natural rate of interest in order to address the saving-investment imbalance (Summers 2014a, 2015a, and 2015b). First, even if nominal interest rates are stuck at the zero bound, real interest rates can still be significantly negative with positive inflation.Bernanke was also critical of this inconsistency, noting that real interest rates can fall to –2 percent with a 2 percent inflation target (Summers 2015b). CPI inflation averaged 1.8 percent in the U.S. during the decade following the global financial crisis and Summers himself (2015c) presents a chart showing that the real yield of ten-year U.S. Treasury Inflation-Protected Securities (TIPS) has been negative for almost two years over 2012–13. Second, Summers (2015c) enters into a circular argument when he uses the decline in real interest rates as a proof of the sharp decline in the natural rate while at the same time blaming “secular stagnation” on the fact that real rates have not mirrored the decline in the natural rate (Summers 2014a, 2015a, and 2015b). Third, the charts with which he illustrates the decline in the natural rate of interest and in real interest rates—for the US Treasury Inflation-Protected Securities (TIPS) and for the world average—do not support his claim, but show a similar downward trend from about 3 percent per annum in 2000 toward zero in 2012–13, only that the former fell faster during the financial crisis (Summers 2014a and 2015c).
The fact that real interest rates followed the natural rate toward zero and even turned negative from 2012 to 2013, makes one wonder why the economy did not exit “secular stagnation” afterward. And yet, as economic growth performance gradually improved in the United States and the validity of his theory was questioned, Summers (2018) defended it forcefully, claiming that the economic recovery was due to “extraordinary policy and financial conditions.” But in doing so, he contradicted his own policy recipe:
There is also a question over whether the current policy mix and financial conditions can be maintained indefinitely. This is doubtful for fiscal policy especially in the US. Monetary policies involving low or negative real interest rates may be sustainable over the long term but they are likely to encourage financial risk, unsound lending and asset bubbles with potentially serious implications for medium-term stability. (Summers 2018)
And he even went further, saying that “[c]urrent palliatives are appropriate but unlikely to be long-term solutions” (Summers 2018), implicitly admitting that his policy recommendations are only short-run placebos. Such easily identifiable inconsistencies show that Summers’s main arguments are seriously flawed. Moreover, his entire theory is refuted by available statistics on savings, investment, productivity, and the estimated level of the natural interest rate, which will be presented in the next sections. But first, the theoretical foundation of the analysis, Wicksell’s “natural rate of interest” theory which was later incorporated into the ABCT, will be introduced.
THE WICKSELLIAN THEORY OF THE NATURAL INTEREST RATE Showing a keen interest in price fluctuations, Wicksell ([1898] 1962) was among the few economists who endorsed the quantity theory of money (when this idea was largely discredited) and tried to improve it further. He noted that interest rate fluctuations played an important role in price changes and concluded that a connection must exist between the “natural” rate of interest which arises in the capital structure of the economy and the rate of interest that emerges on the credit market. Wicksell thought that these two rates of interest are supposed to converge under normal circumstances, in which case the rate of interest on loans is neutral with respect to prices. On the other hand, any persistent deviation of the market loan rate from the natural interest rate would generate a cumulative change in the price level. Keeping the money rate below the natural rate of interest would lead to an increase in prices and vice versa.
Building on the work of Eugen von Böhm-Bawerk, Wicksell argued that the natural interest rate is determined by the supply and demand for real capital goods, as if the latter were lent in kind in an imaginary economy without money. As a result, the natural rate is ultimately determined by the relative excess or scarcity of real capital goods and should be “roughly the same thing as the real interest of actual business” (Wicksell, [1898] 1962, xxv), i.e., the businesses’ return on capital investment.
Although the supply of real capital is limited physically by economic output, the money supply can be expanded without limit in theory. Wicksell stated very clearly that fractional reserve banks are able, especially in concertation, to lend “any desired amount of money for any desired period of time at any desired rate of interest, no matter how low, without affecting their solvency, even though their deposits may be falling due all the time” ([1898] 1962, 111). He even acknowledged the possibility that “the money rate of interest could fall almost to zero without any increase in the amount of real capital!” ([1898] 1962, 111; his italics). This is the extreme case that Summers and the modern proponents of negative interest rates are asking for, supposedly in order to match the fall in the natural rate of interest, which is prevented by the zero lower bound of monetary policy. Although an exact coincidence of the money and natural rates of interest is unlikely, Wicksell argued that any permanent negative difference, even small, between the money and natural rates would raise the general level of prices continuously and to an unlimited level. Therefore, if Summers’s assumption is wrong, reducing the money rate of interest all the way down to zero (or even below) when the natural rate hasn’t changed accordingly is bound to increase prices considerably and negatively impact the economy, as Mises later posited.
Wicksell described in detail the negative impact of the divergence between the money and natural interest rates on changes in the price level, but it was Mises who extrapolated the effects of interest rate manipulation to the capital structure of the economy. This was to become the backbone of his Austrian business cycle theory. According to Mises ([1949] 1998, 521–34), the interest rate is determined by the prevailing “time preference” in the society, i.e., the degree to which people prefer present to future satisfaction. A lower time preference rate will be reflected in a greater share of investment to consumption, a lengthening of the structure of production, and a building up of capital. Mises called “originary” interest the interest rate that is price neutral. This rate is similar to Wicksell’s “natural rate of interest,” and is determined by the discount of future goods versus present goods ([1949] 1998, 539–48). Originary interest is a methodological tool which cannot be attained in a uniform way in the reality of a changing economy and explains the formation of the “gross market rate of interest” on the loan market, which includes in addition to the former an entrepreneurial risk component and a price premium. Rothbard ([1962] 2009, 348–451) elaborated further on the formation of what he called the “pure” rate of interest, which is also determined by time preference and emerges as a price spread between stages of production.
According to Mises’s ABCT ([1949] 1998, 535–83), an artificial expansion of the supply of credit on the loan market can lead to fluctuations in gross market interest rates, i.e., loan rates, even in the absence of an equivalent change in originary interest. When “the market rate deviates from the height which the state of originary interest and the supply of capital goods available for production would require” entrepreneurs are misled into investing in the wrong lines of business, creating “malinvestments,” and households into overconsumption (Mises [1949] 1998, 544). This triggers an unsustainable boom where businessmen overestimate the stock of real savings and embark on “longer processes of production.” This lengthens the capital structure by shifting investment from consumer-goods to capital-goods industries. The resulting intertemporal misallocation of factors of production cannot be indefinite, because the lengthened structure of production can be sustained only through larger real savings, and not through money creation. As soon as the expanded credit reaches the owners of factors of production in wages, rents, and interest, they try to reestablish their preferred consumption-investment pattern and several business investments are revealed as unprofitable. The ensuing recession liquidates the boom’s malinvestment and allows the structure of production to adjust to the new savings and investment pattern reflecting the new natural interest rate prevalent in the economy.
If Summers is wrong and the natural interest rate has not dropped to zero, justifying an equivalent reduction in the monetary policy rate, significant negative economic consequences can follow this reduction according to the ABCT. They go beyond undesired cumulative changes in the price level, as originally claimed by Wicksell, fostering a boom of malinvestment, output losses, and capital consumption. And if the deviation of the market interest rate from the natural rate of interest continues during the ensuing recession, the latter will be prolonged unnecessarily. The economy would be caught in a vicious cycle of dwindling growth and anticrisis monetary policy, exacerbating the economic debacle that looked like “secular stagnation” to Hansen and Summers.
FALLACIES OF THE “EXCESS SAVINGS” ARGUMENT Summers claims that savings have risen while investment has dropped, causing the equilibrium, or natural, interest rate to fall to zero, but he does not specify whether he refers to nominal or real savings and investment. He mentions that a substantial part of excess savings emanate from abroad, but the only statistical evidence that he points to is the rise in the nominal amount of foreign central banks’ reserves of US dollars and US Treasurys, which is a strong indication that he thinks in nominal terms. Moreover, Summers’s idea of the surge in savings derives from the “global savings glut” theory of Ben Bernanke (2005), who tried to pin the widening US current account deficit on an alleged global excess of savings, also measured in nominal terms. Trying to justify a downward trend in the equilibrium real interest rate with nominal data on savings is obviously wrong and this inaccuracy resembles the confusion he makes between nominal and real interest rates. Summers’s methodology is also inconsistent with the way in which Wicksell derives the natural rate of interest, from changes in the supply and demand for real capital goods.
Most important, Summers’s (and Bernanke’s) “global savings glut” argument is refuted by statistical data on global real savings, proxied by the ratio between gross national savings and nominal GDP. Over the last four decades, the world savings ratio has been almost flat, barely increasing from about 24 percent of GDP in 1980 to 26 percent of GDP in 2020 (graph 1). As a matter of fact, the savings ratio had been declining for about 2 percentage points until the early 2000s and started growing moderately only afterward. The much-feared “savings glut,” which allegedly originates in emerging markets, in particular in China, has raised the global savings ratio only marginally, because the saving propensity has dropped concomitantly in advanced economies. Germany has recorded a large increase in its savings ratio since 1980, but this has been compensated for by significant drops in the US and Japanese savings ratios. China’s savings ratio has also trended downward, from above 52 percent of GDP in 2008 to around 44 percent of GDP in 2019, after growing steadily at the beginning of the country’s transition to a market economy.
Graph 1. World savings rate
Source: data from the IMF World Economic Outlook Database. The dramatic fall in investment bemoaned by Summers has not taken place either, according to statistics. The global investment ratio, expressed as gross fixed capital formation to GDP, has been broadly flat at about 26 percent of GDP from 1980 to 2020, and has actually increased in tandem with savings, from around 23 percent of GDP in 2009 to 26 percent of GDP in 2019 (graph 2). Since the financial crisis, savings and investment have balanced out almost every year in both emerging and advanced economies. Therefore, there has not been any global “savings glut” originating from emerging economies, as claimed by Summers and Bernanke. This was to be expected, because a gap between savings and investment at a global level would occur only in nominal terms, i.e., if money newly created by credit expansion were parked in bank accounts and were not spent on new investments. However, such a mismatch would not occur in real terms. In terms of goods, savings always equal investments, as reported in national accounts statistics too, because the part of production which is not consumed is used up in the formation of capital goods, i.e., investment.
Graph 2. World investment rate
Source: data from the IMF World Economic Outlook Database. It does not seem to be a coincidence that the savings ratio started growing in the early 2000s, at the exact time when the Federal Reserve System (Fed), followed by all the other major central banks, reduced interest rates to a historical low level, giving a boost to credit expansion by fractional reserve banks. Deposits in US commercial banks more than doubled in size every decade, from $3.5 trillion in 2000 to above $7 trillion in 2010 and about $16 trillion in 2020.Board of Governors of the Federal Reserve System (US), Deposits, All Commercial Banks [DPSACBW027SBOG], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DPSACBW027SBOG, June 25, 2021. In parallel, foreign exchange reserves of central banks have surged from less than 15 percent of GDP in 2000 to about 30 percent of GDP (Summers 2014). But this reflects primarily an increase in fiduciary media and not in real savings, i.e., output which is not consumed but invested in the production of capital goods. Therefore, Summers and Bernanke mistook for a “savings glut” an abundance of newly created fiduciary media following a radical easing of monetary policy originating in the United States and other advanced economies; however, the growth in bank deposits and foreign reserves does not represent an abundance of real savings available to increase the real stock of capital goods.The Federal Reserve System has gradually cut the federal funds rate to an almost record low of 1 percent from August 2003 to June 2004, a level not seen since the 1950s. The opposite of Summers’s argument is actually true: it was not plentiful real savings that drove down the equilibrium real rate of interest, rather record-low nominal interest rates which spurred monetary credit expansion, as will be elaborated below.For an additional critique of Summers’s neglect of “real savings” in his “secular stagnation” hypothesis see also Shostak (2020).
If time preference goes down in a society and the saving propensity grows, the increase in real savings would be matched by an increase in real investments, i.e., the saving-investment pattern would shift simultaneously. It has been noted that the ratios of saving and investment to GDP, as calculated in national accounts statistics, have increased mildly during the last twenty years. But could this have triggered the claimed significant drop in the natural interest rate? Looking at the evolution of the real stock of capital goods and productivity will provide useful indications given the interconnections between these variables.
WHAT DO PRODUCTIVITY AND CAPITAL ACCUMULATION SUGGEST? According to Rothbard ([1962, 1970] 2009, 526), in the absence of monetary expansion, the real interest rate is supposed to fall in a progressing economy and not in one which is stagnating or regressing, as assumed by Summers. In a progressing economy the production processes are longer and more productive due to an increase in gross investment and capital accumulation, supported by growing savings as time preference and interest rates fall. In a regressing economy, the opposite is true—gross savings and investment decline and consumption increases. Time preference increases together with the interest rate, widening the spread between cumulative prices in the stages of production (Rothbard [1962] 2009, 531). Wicksell ([1898] 1962, xi) argues in the same way that the real rate of interest will fall when the quantity of real capital increases. This is contrary to what Summers claims, i.e., that the natural interest rate has fallen in a stagnating economy, by wrongly assuming that real savings and investments have moved in opposite directions.
A fall in the natural rate of interest is moreover associated with increasing productivity and capital accumulation, as explained by Rothbard, but such an increase has not taken place. In recent years, many economic analysts, both mainstream and nonmainstream, have noted and searched for the causes of a significant decline in productivity in both advanced and emerging economies (IMF 2017; OECD 2016; and Macovei 2018). Organisation for Economic Co-operation and Development (OECD) statistics show that productivity, measured as the annual growth in real GDP per employee, has fallen across the board in most advanced economies over the last two decades (graph 3). Emerging economies, illustrated by China in the chart, have undergone a similar decline in productivity following the financial crisis. One would not have to search much to uncover the mystery of the steady decline in productivity. The same OECD statistics reveal that the annual growth in the capital stock per employee has decelerated significantly over the last two decades, not only in major advanced economies such as Germany, Japan, Switzerland, and the United States, but also in middle-income economies such as South Korea and Spain (graph 4).The capital stock per employee is calculated from the annual change in “capital services,” which is estimated by the OECD using the rate of change of the productive capital stock, taking into account wear and tear, retirements, and other sources of reduction in the productive capacity of fixed capital assets. To ensure data comparability, the OECD capital services measures are based on a common computation method for all countries. See data at OECD Statistics (Growth in GDP Per Capita, Productivity and ULC, accessed June 23, 2021), https://stats.oecd.org/Index.aspx?DataSetCode=PDB_GR. The total capital stock decelerated in the US as well during 2000–09 and only the relatively larger drop in employment during the global financial crisis has caused the capital stock per employee to advance further.
Graph 3. Productivity (change in real GDP per employee)
Source: data from OECD Statistics. Data as of 1995 for the OECD. Graph 4. Capital stock per employee percentage change
Source: data from OECD Statistics; own calculations. Since the global financial crisis, the capital accumulation per worker has slowed significantly in many economies and reached almost zero in countries like Japan and Germany. At the same time, a modest increase in the investment-to-GDP ratio has taken place globally, both in emerging and advanced economies. This may appear counterintuitive but illustrates well the malinvestment that took place both in the boom years before the GFC and thereafter, when aggressive fiscal and monetary policies prolonged the misallocation of factors of production. Even if investment appeared robust, it was actually tied up in wasteful projects that later had to be liquidated and which have not contributed to a durable increase in the capital stock. As the monetary expansion originating in advanced economies spread to the rest of the world via artificially reduced interest rates and large capital flows searching for yield, emerging markets also underwent short-lived consumption or real estate booms due to surging indebtedness during the last two decades (IMF 2015; and BIS 2016).
As a matter of fact, the real cause of the longer-term economic slowdown in many advanced economies has been the gradual erosion of the stock of capital goods, dwindling productivity growth following the offshoring of productive activities to emerging markets, and a drop in the domestic investment-to-GDP ratio of about 4 percentage points since the 1980s. This was brought about by heavy regulatory burdens and welfare policies that limited economic freedom, together with steady credit expansion and increased financial leverage, which led to larger booms and busts. The “secular stagnation” hypothesis not only fails to identify the plausible explanation of the West’s economic decline, but advocates policies that would accelerate it further.
Arguments such as slowing population growth and weak technological progress are, first, not valid and, second, could only play a circumstantial role in explaining “secular stagnation.” The world’s population growth has indeed decelerated from about 1.8 percent per annum in the late 1980s to 1 percent per annum in 2020 (graph 5). Due to the government-enforced one-child policy, a major contributor has been the decline in the population growth of China from about 2 percent per annum to 0.4 percent per annum over the same period.China and India are the two most populous countries in the world, each of them accounting for about 19 percent of world population. India’s population growth also dropped from 2.4 percent per annum at the beginning of the 1980s to about 1 percent in 2020.In countries such as the US, Germany, UK, and France, population growth was pretty constant on average from the 1970s until the GFC and only declined more visibly after the GFC, most likely because of the weak economy due to failed policy response. Yet, despite the steep decline in population growth, investment-to-GDP ratios and capital accumulation advanced significantly in both China and India, which runs against Summers’s argument. The same holds true at the global level, where investment-to-GDP increased (see the previous section) despite the fact that population growth slowed as well.
Graph 5. World population growth rate (% p.a.)
Source: data from OECD Statistics. It should not come as a surprise that investment and capital accumulation per worker increase even if population growth slows, because this is a prerequisite for improving living standards. Countries where the growth of output, investment, and capital stock plummeted or stagnated have been faced with other serious economic issues or misguided polices in addition to the demographic headwinds. Japan is the classic mainstream example of a country whose economic woes are allegedly due to the decline and aging of its population. Yet Japan’s economy has actually never properly recovered from the collapse of its real estate boom in the early 1990s because of ultraloose fiscal and monetary policies and lack of structural reforms. Government intervention has perpetuated the survival of zombie companies and the misallocation of factors of production, resulting in slashed investment, falling productivity growth, and hefty capital outflows, which in turn have gradually eroded the capital stock per worker. And despite a minor decline in population since the Great Recession, Japan’s labor force has actually grown but has increasingly been used in less productive activities while real wages have stagnated (Macovei 2020).
The second argument, about feeble technological advance, is not supported by facts either. Technological progress has actually accelerated over the last two decades if one considers the growing number of patent applications, the increase in research and development (R&D) spending as a share of GDP (graph 6) and the exponential improvement in computing power, microchip capacity, artificial intelligence, big data, and nanotechnology (UNCTAD 2018). However, neither accelerating innovation nor investment can lead to sustainable growth in the capital stock and output if the factors of production are misallocated by counterproductive government intervention. The bottom line is that monetary policy can completely misguide investment if interest rates are set too low due to a gross underestimation of the natural interest rate, as shown in the reminder of the article.
Graph 6. Number of world patents and R&D spending
Source: data from World Bank and OECD Statistics. ESTIMATING THE NATURAL RATE OF INTEREST Summers’s claim that the natural interest rate has declined significantly is based on calculations by Thomas Laubach and John C. Williams, two Fed economists who estimated that the natural interest rate fell to almost zero in the United States during the financial crisis and remained at that level until 2016 (Holston, Laubach, and Williams 2017; and Laubach and Williams 2003). Using a statistical technique known as the Kalman filter, they derived the natural rate of interest from the deviation of the model’s prediction of GDP from actual GDP. The GDP deviation from potential output is used as a proxy for the neutrality of the monetary policy and indicates how much the real federal funds rate has deviated from the natural rate of interest.
The macroeconomic model used by Laubach and Williams suffers from the inherent limitations of economic modeling in general. It provides an oversimplified image of the real world and assumes that past trends will continue unabated in the future. Laubach and Williams did not calculate the natural rate of interest based on past observations, but derived it from projections of an unobservable concept of potential output. There is a more fundamental issue in their specific case, however. As noted by Salerno ([2017] 2020), New Keynesians, including Laubach and Williams, have borrowed Wicksell’s concept of natural rate of interest but applied it differently. New Keynesians have defined the “neutral,” or “natural,” interest rate as the interest rate that prevails when the economy is expanding at its potential rate, i.e., with full employment of factors of production and at stable inflation. As a result, this new concept of a “full employment real interest rate” used by Summers reflects different characteristics than Wicksell’s natural rate, which is only the loan interest rate, which is neutral in respect to commodity prices. Therefore, the results of Laubach and Williams’s model are not necessarily consistent with the natural rate of interest described by Wicksell.
Starting from Wicksell’s original definition, Salerno ([2017] 2020, 122) notes that the natural rate of interest “is nothing but the basic or long-run rate of return on investment in the structure of production,” and makes his own estimates of the natural rate based on the rates of profit for US nonfinancial corporations, as calculated by the US Bureau of Economic Analysis (BEA). The return on investment is calculated either as (i) the ratio of companies’ net operating surplus to net stock of produced assets, i.e., fixed assets and inventory, or (ii) the ratio of companies’ corporate profits to their net stock of produced assets. The numerator, i.e., the measure of corporate profitability, includes the pure rate of interest and entrepreneurial profit. Rothbard ([1962, 1970] 2009, 370) explains that in an “evenly rotating economy” (ERE) the rate of return on investment is equal to the pure rate of interest because there is no uncertainty and the entrepreneurial profit rate is zero.Rothbard also uses the methodological device of the ERE introduced by Mises, which abstracts from change and uncertainty and helps define a state of equilibrium where all prices are final prices, the rate of originary interest is the same for all commodities, and all factors of production are employed to provide the highest-valued service possible. This analytical tool is used to better understand the entrepreneurial function and isolate interest income. In turn, Salerno argues that the entrepreneurial profit rate is close to zero or only slightly positive also in a real economy where output per capita grows very slowly such as the United States. He notes afterward that the US companies’ after-tax average corporate rate of return has varied between 6.2 percent and 8 percent from 2006 to 2015.When using net operating surplus rather than corporate profits to calculate the return on investment, results vary: the after-tax corporate rate of return is then between 11.7 percent in 2009 to 13.6 percent in 2015. Salerno concludes that Wicksell’s natural rate of interest showed no trend of significant decline toward zero as claimed by Summers, but actually increased to around 8 percent in 2015.
This article follows Salerno’s methodological approach and tries to estimate the natural rate of interest based on the BEA’s US National Income and Product Accounts (NIPA), but uses a somewhat different and more granular calculation of capital and corporates’ return on investment. The approach, suggested by Wicksell and elaborated upon by Rothbard ([1962, 1970] 2009, 373),Rothbard has in turn built on the works of Böhm-Bawerk and Frank A. Fetter in developing a unified and consistent theory of factor distribution explaining the relationship between capital, interest, and rent. treats capital differently from other productive factors, such as land and labor.In Wicksell’s ([1898] 1962, 168) own words, “It might be possible to obtain some information from the accounts of individual enterprises and from the annual reports and dividends of companies. But it has to be remembered that the thing that is commonly regarded as interest does not correspond to the use to which we are applying the term; for it usually covers not only interest on liquid capital, but consists far more largely of rents of every kind: rents of land, monopoly rents, the return on buildings and durable machinery.” The production of capital is imputable in the long run to land, labor, and time; capital is therefore not an independent factor of production that earns a net interest rent for its owner, not least because capitalist-entrepreneurs take a risk in advancing money to the other factors of production “in the expectation of being able to recoup their money with a surplus for interest and profit after sale to the consumers” (Rothbard [1962, 1970] 2009, 355).In other words, interest income is not derived from concrete capital goods, but from the fact that capital owners restrict their present consumption and advance present goods, i.e., money, to factor owners who are producing the future goods that capitalist-entrepreneurs acquire, hold, and process before they later sell to consumers. For this service of advancing time to the owners of factors, capitalists are paid the pure interest, which is equivalent to the price discount between present and future goods (Rothbard [1962, 1970] 2009,348 and 374).
Accordingly, the businesses’ return on investment is calculated by subtracting from the net operating surplus of private enterprisesPresented in BEA NIPA (table 1.10, “Percentage Shares of Gross Domestic Product,” last modified May 27, 2021), https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=2&isuri=1&1921=survey. all advances to factor owners which are not directly linked to interest on “liquid capital,” such as “rental income”, “proprietors’ income” which includes a significant wage component of sole proprietorships and partnerships, and negligible “business current transfer payments.” The result includes the sum of “corporate profits adjusted for inventory valuation and capital consumption of domestic companies”This adjustment is important to exclude from corporate profits “capital gains or losses, which reflect changes in the prices of existing assets, but not in the real stock of produced assets” and account for the consumption of capital in production. and of “net interest paid on financial assets.” This amount is divided by the net stock of produced assets (private and nonresidential),Presented in BEA NIPA (Table 5.10, “Changes in Net Stock of Produced Assets (Fixed Assets and Inventories),” last modified Sept. 2, 2020), https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=2&isuri=1&1921=survey. to which, deviating from the results presented by Salerno, the capitalists’ expenditure on factor incomes, labor, and land are added. According to Rothbard, investment in each stage of production includes both durable and nondurable capital goods. The latter represent the services of original factors which, although assimilated to consumer goods in mainstream economics and statistics, are actually mixed with existing durable capital in the production process in order to yield a final product. As a result, Rothbard ([1962] 2009, 401) argues that “it is inadmissible to leave the consumption of nondurable goods out of the investment picture” and to “single out durable goods, which are themselves only discounted embodiments of their nondurable services and therefore no different from nondurable goods.”
According to this calculation, the US companies’ return on investment, which is here assimilated with the normal, i.e., natural, rate of interest in the real monetary world, varied between 5 percent and 7.8 percent from 1951 to 2019 (graph 7). The level of about 6 percent recorded over 2015–19 refutes once more Summers’s assertion that that natural rate of interest has declined to almost zero in the United States since the Great Recession. There has been a moderate decline in US companies’ return on investment from 7.5 percent in 1985 to around 6 percent in 2019, split between a larger drop of about 2 percentage points in the rate of net interest payments and an increase in the rate of corporate profits of about 0.5 percentage points. This decomposition of return on investment illustrates well the fact that even if loose monetary policy and credit expansion have artificially reduced the loan interest rate in the economy, the return on investment, i.e., the discount between present and future goods, has not been reduced proportionally, because business uncertainty drove up the entrepreneurial profit component.
Graph 7. Natural rate of interest (% p.a.)
Source: data from US Bureau of Economic Analysis; own calculations. It is hardly possible to achieve a precise decomposition of the return on investment into its two components, identified by Mises and Rothbard—natural rate and profit risk rate—in the absence of modeling approximations. But it does not even appear to be necessary to make this split, because “the interest rate is equal to the rate of price spread in the various stages” of production, which tends to be uniform for every good and every stage throughout the economy (Rothbard [1962, 1970] 2009, 371). In a real market economy this interest rate deviates from the natural or pure rate of interest, because uncertainty creates entrepreneurial risk. However, as Salerno explains, these deviations are likely to be modest, not least because the market process selects the entrepreneurs which are most able to deal with uncertainty. At the same time, increased government intervention in the economy can add to uncertainty and may raise the entrepreneurial risk rate, as seems to have happened in the US economy over the last two decades (graph 8). Nevertheless, this would only increase the spread between the various stages of production and the discount between present and future goods, which is in fact the interest rate guiding economic activity and reflecting changes in time preference.
Graph 8. US business confidence index
Source: data from FRED. According to the calculation presented here, the natural interest rate did not drop to zero after the financial crisis and has actually remained consistently and significantly above the federal funds rate and the bank loan prime rate since the early 2000s, when monetary policy was eased significantly (graph 9). Moreover, the gap has widened considerably since the Great Recession, contradicting Summers’s “secular stagnation” hypothesis. At the same time, the large deviation of both the key monetary policy and the bank lending rates from the natural rate, accompanied by an acceleration of credit growth to double-digit rates at the onset of the boom preceding the GFC fits the Austrian business cycle theory very well (graph 10).For a detailed account of how the economic developments surrounding the GFC can be explained by the ABCT, see Salerno (2012).
Graph 9. Interest rates vs. the natural rate (% p.a.)
Source: data from FRED and the BEA; own calculations. Graph 10. Bank credit expansion (% p.a.)
Source: data from FRED. A final argument that Summers (2015a and 2015c) made to reinforce his claim that monetary policy had not been expansionary was the perceived “substantial decline in the rate of inflation” and outright fears of deflation in the wake of the financial crisis. Although Consumer Price Index (CPI) inflation has moderately trended downward in the United States since the early 1990s and was briefly slightly negative at –0.4 percent in 2009 (Graph 11), Summers’s reliance on a single inflation indicator can be very misleading about the underlying inflationary pressures and structural imbalances in the economy. First, consumer price inflation has averaged about 1.8 percent per year since the GFC and until the start of the COVID-19 pandemic,US Bureau of Labor Statistics; Consumer Price Index (CPI) Databases; All items in U.S. city average, all urban consumers, not seasonally adjusted; series ID CUUR0000SA0; https://data.bls.gov/cgi-bin/surveymost; June 25, 2021. which is very close to the Fed’s annual inflation target of 2 percent, thus invalidating Summers’s fears that inflation would persistently remain below target. Second, as Rothbard ([1962, 1970] 2009, 1003; his italics) notes, “credit expansion raises prices beyond what they would have been in the free market and thereby creates the business cycle.” The fact that inflation decelerated is not the relevant point, because consumer prices continued growing consistently when deflation should have accompanied a curative recession following the GFC. Rising consumer prices, in particular when labor productivity was also growing by about 1 percent annually (OECD, 2021) and the recovery was incomplete and dependent on unprecedented government support, indicates that the market rate continued to be set below the natural interest rate and not the opposite.Salerno ([2017] 2020, 120) explains that Wicksell’s cumulative increase in the price level implies a steady increase in the price level, not necessarily accelerating inflation, and refutes Selgin’s claim that zero interest rates were not the result of the Fed’s expansionary monetary policy. Third, the long-term decline in CPI inflation was most likely due to other factors than an alleged restrictive monetary policy. Williams (2021) claims that CPI inflation in the United States has been underestimated due to changes in the calculation methodology. According to his “Alternate Inflation Chart,” which calculates CPI inflation with the 1990 formula, inflation has actually ranged between 4 and 6 percent annually for the past decade.
Graph 11. CPI and import price inflation (% p.a.)
Source: data from FRED. In addition, the mainstream definition of inflation as an increase in prices is considered inadequate by Austrian economists. Price inflation lumps together different monetary and nonmonetary causal factors, based on both voluntary changes in preferences on the market and government intervention, which have different consequences for the structure of production, incomes, and individual wealth. Therefore, Austrian economists define inflation as an increase in the supply of money beyond any increase in specie, i.e., commodity money such as gold or silver (Rothbard [1962, 1970] 2009, 1021–22). According to this definition, monetary policy was clearly expansionary after the financial crisis, as the Fed increased the monetary base almost five times from August 2008 until a prepandemic peak of about $4 trillion six years later (graph 12). Broad money supply increased at a slower pace due to the postboom debt overhang, bank balance sheet repair, piling up of excess reserves with the Fed, and greater uncertainty, which bolstered cash balances. Yet, the M2 monetary aggregate almost doubled to around $15 trillion from 2009 until 2019, triggering substantial asset price inflation. The stock market, as reflected by the S&P 500 Index, increased by over 260 percent, whereas housing prices, according to the S&P/Case-Shiller U.S. National Home Price Index, increased by almost 60 percent from their post-GFC troughs until the end of 2019.Macrotrends; S&P 500 Index - 90 Year Historical Chart; https://www.macrotrends.net/2324/sp-500-historical-chart-data; June 25, 2021 and S&P Dow Jones Indices LLC, S&P/Case-Shiller U.S. National Home Price Index [CSUSHPISA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CSUSHPISA, June 26, 2021. Moreover, substantial net financial outflows and a strong US dollar, facilitated by the latter’s “exorbitant privilege,”This refers to the advantage derived by the US dollar as the world’s international reserve currency in terms of increased foreign demand for US dollar cash holdings, following the Bretton Woods arrangement. have limited the impact of the large monetary expansion on domestic consumer prices. This is illustrated by subdued import price inflation, which held back overall CPI inflation in the United States (graph 11).
Graph 12. US money supply
Source: date from FRED. According to the ABCT, the depression is the recovery phase which allows market forces to liquidate the malinvestments and distortions from the boom while the economy moves toward a higher natural rate of interest. The latter provides incentives to entrepreneurs to start new investments that deliver sound economic growth. During a depression, a higher natural rate of interest is implicit in a larger price differential between the various stages of production, which is usually the result of a contraction in the supply of money and credit (Rothbard [1962, 1970] 2009, 1005–06). But this curative recession has not taken place in the wake of the financial crisis. Policies advocated by Summers, such as the Fed’s drastic cut of the policy rate down to zero and aggressive quantitative easing have maintained the misalignment of the bank lending rates with the natural rate of interest, inflating both the money supply and the price level. This has prolonged the boom’s distortions in the structure of production and relative prices, hampering a sound economic recovery and stoking the next crisis, as evidenced by the growing asset price bubbles, which were subsequently exacerbated by the unprecedented monetary and fiscal stimulus during the COVID-19 pandemic.
CONCLUSION Summers’s new “secular stagnation” hypothesis has been instrumental in providing a theoretical justification for the extension of ultraloose monetary and fiscal policies in the aftermath of the global financial crisis even as they failed to revive economic growth. His main argument that an excess of savings over investment has led to a significant decline in the natural rate of interest not only suffers from inner inconsistencies, such as the insufficient distinction between nominal and real interest rates and between nominal and real savings and investment, but is also refuted by available statistics on savings, investment, capital stock, and productivity. Moreover, his claim that the natural rate of interest has dropped to zero while monetary policy has been constrained by the zero lower bound is wrong. Both the federal funds rate and the bank prime loan rate have been consistently suppressed well below the natural rate of interest since the early 2000s, triggering and subsequently prolonging the current business cycle, as anticipated by the Austrian business cycle theory.
It follows that Summers’s policy recommendations, which he himself calls “palliatives” and “unlikely to be long-term solutions,” are also bound to do more harm than good. Before the United States and other major economies worsen their decline in productivity growth and head toward long-term stagnation, punitive indebtedness, and gradual impoverishment, it is time to change course, normalize monetary policy, and reduce the heavy burden of interventionist policies. This would clean up malinvestments, realign the structure of production with the time preference prevalent in society, and rekindle business initiative and sound growth. If policies to stimulate demand have not worked for about three decades in Japan and for one decade in the rest of the world, then it should be obvious to policymakers that this has been the wrong recipe all along.Several contemporary Austrian economists have argued that the 2020 financial crisis and economic slump were already in the making before the COVID-19 pandemic hit. See Bishop (2020).
Download the slides from this lecture at Mises.org/MU21_PPT_16.
Recorded at the Mises Institute in Auburn, Alabama, on 20 July 2021.
Vijay Boyapati left a lucrative job at Google in 2007 to move to New Hampshire and campaign for Ron Paul. In this episode, Vijay explains why the other Austrians should have listened to him in 2010 when he warned that their inflation predictions were wrong. He also explains his popular 2018 essay, “The Bullish Case for Bitcoin.”
Mentioned in the Episode and Other Links of Interest: Vijay Boyapati’s 2010 article on credit deflationVijay’s 2018 article on “The Bullish Case for Bitcoin”Bob’s guide (with Silas Barta) to BitcoinBob’s article on Hayek on private fiat moneyBob explains his botched inflation prediction For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on Apple Podcasts, Google Podcasts, Stitcher, Spotify, and via RSS.
It seems that governments want to convince us that they have saved the world when the reality is that the misguided lockdowns were the cause of the economic debacle and lifting them is the main cause of the recovery.
Original Article: "The US Recovery Is Weak, Especially Given the Size of the "Stimulus"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
James Grant is editor of Grant’s Interest Rate Observer, which he founded in 1983. He is the author of nine books, including Money of the Mind, The Trouble with Prosperity, John Adams: Party of One, The Forgotten Depression, and more recently Bagehot: The Life and Times of the Greatest Victorian. In 2015 Grant received the prestigious Gerald Loeb Lifetime Achievement Award for excellence in business journalism. James Grant is an associated scholar of the Mises Institute.
Kevin Duffy is principal of Bearing Asset Management, which he cofounded in 2002. The firm manages the Bearing Core Fund, a contrarian, macro-themed hedge fund with a flexible mandate. He earned a BS in civil engineering from Missouri University of Science and Technology and has a passion for financial history, Austrian economics, and pithy quotes. He also publishes a bimonthly investment letter called the Coffee Can Portfolio. Duffy attended Mises University in 1990 after seeing Lew Rockwell on CNN’s Crossfire in 1989.
Kevin Duffy interviewed James Grant for his newsletter Coffee Can Portfolio. It is reprinted with permission.
KEVIN DUFFY: 2020 has been part dystopian fiction, part tulip mania. How do we reconcile the two?
JAMES GRANT: I’m not sure there’s much distinction. To me, the current form of dystopia is the bubble form, so I think this is the year of the dystopian bubble.
KD: There has been a worship of authorities. For the past thirty-seven years you’ve focused mainly on the Fed, but this year we’ve seen a reverence for medical authorities. Who has done more damage?
JG: The medical authorities remind me of the economic authorities. Both pretend to draw a bead on the future. Let’s compare them both to the meteorological authorities. The National Weather Service spends over a billion dollars a year and takes tens of millions, if not billions, of discrete observations of wind, weather, tide, temperature, what have you. But notice the five- and ten-day forecasts on your trusty iPhone are ever changing. This is the weather. Temperature gradients don’t have feelings, they don’t get jealous of the millionaire next door, they don’t watch CNBC, yet our forecasting ability goes out, maximum, ten days. Even so, the economists think nothing of calling next year’s GDP.
KD: This sounds very much like Friedrich Hayek and the pretense of knowledge. There’s a certain hubris taking place. What might the alternative to top-down planning look like?
JG: Counselor is leading the witness! “Pretense of knowledge” is a three-dollar phrase; in Brooklyn it’s called bluffing. Of course knowledge is dispersed. Every individual knows what he or she wants. An economist would say that we know our own demand curves and supply curves. Governor Cuomo can only guess—as brilliant as the governor is—at what we want and what risks we are prepared to run with our lives.
I am seventy-four years old and every day I get out of bed I am beating the odds. The idea of suspending ordinary living pending the arrival of a vaccine is absurd. Still worse is the forced suspension of the lives of people seventy years younger than I. My grandchildren, for instance. “We can’t sacrifice our children out of our own fear,” said Dr. Scott Atlas in so many wise words.
Life is a matter of tradeoffs. And early on people would plague you if you held this view in public by saying, “You mean to tell me that you are willing to trade off profits for human lives?” Well no, I’m willing to trade off risks, and it’s what we all do, whether we realize it or not, whether we can express this or not. We are all, at least subconsciously, living according to our tolerance for risk. We look both ways or no, we don’t look both ways. We scrupulously observe fifty-five miles an hour or we are young and quick and bold and drive seventy-five miles an hour and probably not run a risk to ourselves or others. So people by and large, not exclusively and not entirely, but people by and large know these things about themselves. And what Hayek was driving at is that the Soviet Union failed for a reason.
KD: Let’s take a step back and talk about some of the early influences on you. When did Jim Grant start to become “Jim Grant”?
JG: July 26, 1946.
KD: [Laughter] When did you realize you were an independent thinker? Was there a lightbulb moment or were you just wired that way?
JG: I’ve always been a “yes, but” guy, a skeptic. At Indiana University, I took a course in the history of economic thought. It gave me a sense of the cycle of ideas—how today’s certitudes become tomorrow’s heresies.
Ideas about markets, individual enterprise, individual freedom—they wax and they wane.
Edmund Burke, in his monumental Reflections on the Revolution in France, described English financial arrangements along about 1790. He pointed out that there was no legal tender law in Britain. The only kind of money a creditor had to accept for a debt was gold or silver. Not even the Bank of England could force its notes on the public. Could anything be better, more equitable? Not for me, but notice that system is extinct.
You could say that economic freedom, broadly defined, peaked around 1914, the year following enactment of the income tax and the signing of the Federal Reserve Act.
KD: And the direct election of senators…
JG: Right. And then came World War I, following which (after the 1920s roared) was the war mobilization of the 1930s and 1940s. High taxes, heavy regulation, economic regimentation. But statism, too, has its cycles. The 1947 founding of the Mont Pèlerin Society, a group of old-style liberal thinkers led by Friedrich Hayek, might represent the bottom of the long twentieth-century bear market in economic liberty.
KD: The roots of our monetary meddling go back further, don’t they—even to the Civil War?
JG: Right. It was to fight that war that the Lincoln administration issued the first greenbacks— paper money not convertible on demand into gold or silver. Salmon P. Chase, Lincoln’s Treasury secretary, pushed the greenback plan while holding his nose. He called the legal tender clause “repugnant,” a form of monetary coercion. Later, as chief justice of the United States, he actually judged that clause to be unconstitutional. Subsequent course held otherwise, of course, and the green notes in your wallet today are “legal tender for all debts public and private.” Hardly anyone gives it a thought. Certainly the precedent for what happened in 1913 was set many decades before during the Civil War.
KD: So 1913 brought us the modern incarnation of our central bank, the Federal Reserve. Its first test, from a monetary policy standpoint, was the depression of 1921, which you wrote about in The Forgotten Depression. What was the policy response back then, and how was it different than today?
JG: The policy response was old-time religion. It was monetary and fiscal orthodoxy. President Warren G. Harding inherited a rip-roaring depression in 1921. The roots of that business cycle downturn lay in the wartime inflation of 1914–18. America entered the war in 1917 and proceeded to do what belligerent countries invariably do—to spend more than they earn and to borrow the difference.
The Harding administration balanced the budget—so no fiscal stimulus. Real interest rates were punitively high—there was no QE. Treasury secretary [Andrew W.] Mellon used his influence to reduce those rates. Meanwhile prices fell and wages fell. The stock market was sawed in half. Corporate profits collapsed. Unemployment was then unmeasured, but it soared. But the price mechanism, more or less freely functioning, did its job. Because wages did fall, businesses could regain profitability at lower levels of prices.
The depression of 1920–21 began in inflation, ended in deflation, but it did end: eighteen months from business cycle top to business cycle bottom.
Compare the Hoover administration’s response to the 1929 stock market crash. President Herbert Hoover (he had been Harding’s secretary of commerce) called on business leaders like Henry Ford not to cut wages. And they didn’t, with the result that falling prices, not neutralized by falling wages, devastated corporate earnings, and thus corporate investment. Mass unemployment followed.
KD: The Fed also responded to the slump by injecting money into the financial system by buying government securities. And yet Milton Friedman and others claimed they didn’t do enough.
JG: Yes, that was the lesson according to Milton Friedman and Anna Schwartz. They wrote this big, thick book, always referred to as a magisterial history, A Monetary History of the United States. Its most famous chapter is called “The Great Contraction, 1929–33.” Friedman says the money supply declined by a third, and he thought that that was what put the “great” in “Great Depression.”
Ben Bernanke, you recall, on the occasion of Milton Friedman’s ninetieth birthday apologized to Milton and Anna, saying, “Regarding the Great Depression, you’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
They have not done it again. And they have done everything in their power to ignore the lessons of 1920–21, too. They are all in for interest rate suppression and other such radical nostrums— the “buttinski method.” Do you know what a buttinski is?
KD: No, I don’t.
JG: Somebody who butts in. To them, interest rates are not prices to be discovered in the market, but administered by experts like themselves.
KD: This cycle is perhaps unique in the sense that there is so little price discovery while there are so many price-insensitive buyers, not just the Federal Reserve, but also index fund investors and virtue-signaling millennials. How price insensitive are the banks, and how coerced are their purchases of government bonds?
JG: Well, they need the government securities to fulfill the regulatory requirements for so-called high-quality liquid assets. And yes, central banks are price insensitive, credit insensitive, value insensitive, and they are buyers of corporate debt as well as of government debt and, in some countries, of equities besides.
KD: Why has this so-called “everything bubble” gotten as big as it has? Has that surprised you at all? It certainly has me.
JG: Oh yes. I wake up surprised and go to bed surprised. I mean, consider the $17 trillion plus in securities priced to yield less than nothing. That’s a surprise. It’s a singularity, nothing like it in the entire history of interest rates. Certainly, a financial journalist is privileged to live in this world in which so much is new, so much is to some sense shocking (or gratifying, depending on how you’re positioned).
KD: A friend once said, “It’s okay to forecast the end of the world, just don’t ever give a date.” When people ask you about timing, what do you tell them?
JG: Oh, I’ve become very wily. Years ago, someone asked me to forecast the ten-year yield one year hence, and I had the presence of mind to say no, thank you. I count that as my journalistic coming of age. Only rookies pick levels and dates.
KD: Is it easier to look ten years out? If you take the long view, what do you feel confident in predicting?
JG: I’m fairly confident about the arc of monetary change. Every succeeding crisis brings a more muscular monetary response—a lower funds rate, a larger Fed balance sheet. But ultra-low rates encourage more credit formation, which leads to greater fragility and thus to the next crisis. The Fed is arsonist and fireman all rolled up into one.
KD: Let’s consider a scenario. Let’s say in the next year or so we get a severe global recession which starts to tip over some of these credit dominoes. How might such a scenario play out?
JG: It depends on the nature of the financial crisis. Say it’s an inflationary one. And say that instead of 2 percent inflation, it’s 4 percent or 5 percent. The indicated response would be to raise the federal funds rate, but rivets start popping when money gets tight in a leveraged economy.
KD: So we’re in an inflationary crisis. Let’s face it, the Fed has had a license to print money partially due to Amazon driving prices down. There’s also been a commodity bust. Everything has gone their way. Are you suggesting, in your own words, that “inflation is kryptonite to bonds” and that this is something the Fed does not anticipate?
JG: Well, as a rule, the Fed anticipates nothing. As a rule, most of us anticipate nothing, the future being complex and, for the most part, unpredictable. By the way, the phrase “foreseeable future,” is an oxymoron.
Yes, inflation has been a no-show, though maybe that’s changing. Charles Goodhart and his coauthor Manoj Pradhan, in their fine new book, The Great Demographic Reversal, point out that the past thirty years have delivered a huge positive supply shock. That is, a supply shock in labor. But they contend that, for a number of reasons, the future will be very different, featuring rising inflation and interest rates alike. It’s an impressive and persuasive argument they make.
People my age will no longer be productive, the book says. They will be needful, they will be in the hospital, they will be attended to by their loving aides who will help them either walk or remember, or both. And the dependency ratio [the ratio of those not in the labor force to those in it] is going to rise. So there will be less labor serving and greater demand. And I will add that these will be added to the perhaps inevitable central bank response, which is to be more generous in provisioning the system with money and credit.
So all of this is going to add up to years of inflation, which will shock the bond markets, especially that portion of the bond market, the $17 trillion portion, which is now priced for the certainty—not the risk, mind you, but seemingly the certainty—of either stable prices or gently dwindling prices. What the world is not set up for is an inflation, to be sure.
KD: Just to clarify, you’re talking about labor from China, particularly, and from India…
JG: India, Eastern Europe.
KD: So we’ve gotten the benefits, up front, but these people, as they prosper, will demand more energy, more protein, etc. Are the authors saying the demand side is coming with a lag and that, in turn, adds to inflationary pressures?
JG: Yes. I’m going to read you a paragraph from this book.
It’s China’s “globalisation and the reincorporation of Eastern Europe into the world trading system, together with the demographic forces, the arrival of baby boomers into the labour force and the improvement in the dependency ratio, together with greater women’s employment [that] produced the largest ever, massive positive labour supply shock. The effective labor supply force for the world’s advanced economy trading system more than doubled over those 27 years, from 1991 to 2018.”
But that’s in the bank. It’s behind us. What lies ahead is a deteriorating dependency ratio. More needy people, fewer productive ones, fewer working ones, perhaps more monetary stimulus, and rising prices at the checkout counter rather than falling ones.
KD: In North America, the oil rig count is down 61 percent year-to-date and the natural gas rig count is down 18 percent. So on top of all of this, we’re now getting a commodity supply shock. Is this another tailwind for commodities?
JG: Yes, and you don’t need a big inflation to generate returns. Years of subpar investment in productive capacity in the things that the world needs more of is the essence of the bull case. The key is the supply side.
KD: Socially responsible investing, a.k.a. ESG [environmental, social, and governance], has led to fossil fuel divestment as well. How does ESG enter into the equation for investors?
JG: ESG is a bull-market luxury. In a bear market, people, I think, are much more concerned about survival than they are about making a political statement.
Will Thomson, founder and managing partner of Massif Capital LLC, has a really smart approach to choosing effective ESG-themed investments. Don’t go buying the exchange-traded funds labeled ESG, he says. They own Apple and Microsoft and Facebook and Alphabet. Instead, buy the kind of dirty industrial business that’s cleaning itself up. It makes sense to me.
KD: That’s an interesting arbitrage. Is there a similar opportunity in more accurate accounting? I’m thinking about a company like Tesla, where everyone is focused on the lack of emissions, but they’re overlooking where this electricity is coming from, not to mention the costs of recycling batteries.
JG: I am all for better accounting. And now Tesla’s entering the S&P 500 on the strength of its virtue and flash and momentum and of the tax credits by which alone it achieves profitability. So there’s a singularity of the year 2020 along with $17 trillion in negative-yielding bonds.
KD: You talked about the cyclical nature of markets. Right now youth is elevated. Has the digital revolution made this a young man’s game or is there still room for elder wisdom?
JG: Based upon my experience, there’s no room for elder wisdom.
KD: [Laughter]
JG: Raging bull markets are always young people’s thing. Old guys always say, “I wouldn’t be so quick to pay 170 times revenues for that particular stock. I seem to recall something like this in 1968, or was it 1868?” This is what old people always sound like. Do you remember the author George Goodman? I think his pen name was Adam Smith; he wrote a book called The Money Game.
KD: Oh sure. The go-go ’60s.
JG: If you’re starting a hedge fund, you want young people buying the stocks that are going to go up. Because they don’t know enough not to buy them. People who know enough not to buy them are going to underperform. So in a way it was ever thus. Youth will be served, and youth especially will be served in great raging liquidity-driven bull markets.
Witness bitcoin and the charm and the demonstrated excellence of the FAANG [Facebook, Amazon, Apple, Netflix, Google] stocks. The young people don’t imagine that they have great business models. What they do imagine is that the possibilities for expansion are infinite, whereas the expansion may be limited in the case of Facebook, for example, by such mundane things as the size of the world’s advertising market.
But those objections, the wisdom of the ages, play very badly on the upswing. Again, I think this is nothing new.
KD: Regarding youthful exuberance, I remember the late ’90s tech bubble. On February 15, 2000, 60 Minutes aired a story by Bob Simon called “Dot- Com Kids” where Simon interviewed several young founders of web-based startups that were housed in old buildings in downtown Manhattan, dubbed Silicon Alley. One even told him, essentially, “We’re coming after your job. You’re going to be roadkill.” I guess it didn’t quite turn out that way, did it?
JG: No, but in fairness there’s something to this. There’s something to the displacement of human beings by human ingenuity. It is certainly a fact that technology has improved lives, reduced costs, increased comfort, amused countless millions, and cost some jobs while creating others. That’s the nature of capitalist progress. Capitalist progress is not always to everyone’s aesthetic taste, but it is the ultimate democratic expression of how resources ought to be allocated. The sovereignty of the consumer, whatever the consumer’s taste might be, that’s what will be served.
So young people, whether they can express it just that way or not, do live it. They buy what they themselves like, and what they like often mystifies their elders.
KD: Elders often worry about the next generation. Look at some of the toxic ideology young people have imbibed. How concerned are you? Is there hope?
JG: Oh, of course. I am the father of four and the grandfather of five, and those nine people are fabulous!
KD: That’s the hope! That’s the future.
JG: Right, but everybody else is very questionable.
KD: [Laughter]
JG: Go back to the ’30s and Marxism, without any of the gloss of democratic liberalism, Marxism itself— hammer and claw—was culturally and politically prevalent. And if it wasn’t Marxism, it was the vogue in fascism. We forget that the top tax rate in the Eisenhower years was in the upper ’80s, in fact, into the ’90s. Very few people actually paid that, but that was a legacy of the ideas that reigned, not quite uncontested, but dominated in the ’30s and into the ’40s. That gradually gave way, but don’t forget what happened in the ’60s. There was a Marxist resurgence and then, lo and behold, come the inflationary ’70s, and people find they’ve had enough of that, and then comes Ronald Reagan.
So there’s a cyclicality, there’s an episodic quality to our politics. I don’t think these are end times politically. I think it’s worrying that freedom of speech seems to be back on its heels as much as it has ever been. Freedom of speech, in America, was not quite so endangered even in the ’30s as it is now. That is genuinely frightening. I’m frightened by it.
KD: Rollo May, an American psychiatrist, once said, “The opposite of courage in our society is not cowardice, it is conformity.” It seems like we’re at a point in time when it takes courage to distance oneself from the crowd and from some of these really toxic ideas.
JG: It takes steadfastness, though just how much depends. If you are in a position to lose your job and instead of holding on to that job in the face of ideas and the insistence on ideas you think are wrong, instead of that, you stand up and you object at the risk of losing your livelihood in the case of this master of Eton College in England [he was fired for refusing to withdraw his posted lecture on the virtues of manliness] (and he has five kids)—if you do that, that is courageous.
If you have your own soapbox and you are not really at risk of losing your livelihood, it takes a modicum of bloody mindedness to stand up in front of a mass of opinion. It takes a certain amount of moxie to risk social ostracism. That’s part and parcel of it sometimes, but it doesn’t require a Medal of Honor in that setting. So that’s the distinction I wanted to draw: it depends on how you’re situated in life.
KD: CNBC certainly isn’t the worst of the cancel culture, but nonconformists like Peter Schiff, Marc Faber, and Michael Pento have all been excommunicated. Jim Grant is still there. How have you been able to pull that off?
JG: I’m not sure that the premise of the question is quite correct. I’m on the squawk box every so often, but not very frequently. Take another kind of financial personage. Ed Yardeni is a successful economist. He’s made his living by serving his clients, by trying to make money for them without passing judgment on public policy. Whether the Fed is doing the right thing or the wrong thing is not his remit, he says. His remit, in fact, is not fighting the Fed, but adapting to monetary policy (whatever it is) to make money.
So people like you, like me, like others you mentioned, have chosen a different job description. Grant’s takes a stand on the integrity of the currency. It takes a stand on the nature of markets. It takes a stand on price discovery as opposed to price administration. And we say those things in public and print. We say them on air when given the chance. But they have not lately helped people make money.
CNBC’s viewers—I think most of them—want to know where the markets are going, and if you are not on the right side of that question, you wear out your welcome as a public voice. So I don’t begrudge the producers at CNBC for choosing people with a hot hand.
I am happy, retrospectively, to have been in the wilderness in the early 2000s. Let’s not forget how long they lasted: 2001, ’02, ’03, ’04, ’05, ’06, ’07, yes?
KD: I remember.
JG: If you had had a correct, informed, bearish view on house prices and mortgage-backed securities, you were more than a half decade of wrong before being gloriously right. You have to stick with your guns and have to believe in what you believe and accept that the world can get tired of hearing your foreboding (or, as the case may be, annoyingly bullish) voice.
KD: At a time when other skeptics are routinely dismissed as “the bear crying wolf,” you have somehow managed to stay relevant. The bottom line is you are delivering value. You’re doing a lot more than just bashing the Fed. Grant’s has made some great bullish calls over the years. For example, you saw the economy recovering in 2009 and were bullish on Google fairly early in the bull market, when it was considered a value stock. I would posit that the reason you have this platform is that you’re not just a broken record.
JG: Well, thank you. I am happy to agree with that, and I would credit the fine analysts we have had here over the years. Now, of course, Evan Lorenz is a terrific securities analyst, and, way back when, Dan Gertner—this in 2006 and 2007—did a lot of very early and important securities analysis on complex mortgage structures.
So, yes, thank you. We have indeed earned a voice. I think sometimes, when I get discouraged, that we have earned our reputation a little bit too well of being critics of contemporary monetary arrangements, but I wouldn’t change that. I think that these institutions and these policies are wrongheaded. I think they are dangerous. I think they are possibly even bad for the planet!
It comes down to, Where do you want to make a stand? What matters to you? What matters to me—and to my journalistic lemonade stand—is not saying the correct things to insinuate myself into the good graces of the financial establishment. It’s speaking up against bubbles and the monetary manipulations that inflate them. It’s speaking up for the incredibly outré institutions of the gold standard and for the great institution of corporate solvency (you’d be surprised how controversial it can become at the end of a boom).
That’s the way we’ve run things for a long time. We’ve been in business for thirty-seven years, and that’s the way we intend to keep doing it.
KD: You recently published the “Grant’s Manifesto,” in which you actually tooted your own horn (very unusual), specifically your track record of identifying excesses. Looking at this everything bubble, where do you see the areas of greatest fragility?
JG: To me, the most excessive of all the excesses is these $17 trillion plus of nominal negatively yielding bonds. Nothing like it in four thousand years of interest rate history. They seem to be priced for one outcome alone, the noninflationary one.
Cocksure people baffle me. You run across them all the time on Wall Street, somebody who simply declares, “this is going to happen,” or “that’s going to happen.”
How do you know that? This is a probabilistic world; it’s not a world of certainty.
The great nineteenth-century historian Thomas Babington Macaulay was one of the type. “I wish I was as certain of anything as Tom Macaulay is of everything,” someone said of him. I feel that way with a lot of the Wall Street pundits I read and listen to.
The people who are holding on to these guaranteed- loss securities seem certain of the benevolent path of stable or falling prices. I think by the time Mr. Market puts them through the slicing and dicing machine, there won’t be much left of them.
KD: Will the next banking crisis have sovereign debt at the center of it?
JG: It could. It’s one candidate. Corporate credit is another. With every downward lurch in the stock market, central banks barge in to help. But in helping—with their credit infusions and interest rate slashing—they invite still more lending and borrowing, therefore greater leverage, therefore greater fragility, therefore a greater likelihood that the next financial disturbance will elicit an even greater monetary response, thereby bringing still more leverage, more fragility, etc., and on and on.
KD: Until something breaks.
JG: And maybe that something is going to be the people’s confidence in the central banks.
The central bankers have gotten everyone flummoxed. How would you like to own the stock of a company like the Fed, that did not, shall we say, distinguish itself in 2005, ’06, ’07, ’08, ’09, yet comes out of it with greater power, more prestige…? Now that’s a franchise. My hope is that the next crisis will become also a crisis of belief in central banks and in the judgment of the people who staff them.
One of the big trends of the past century is the socialization of financial risk. Increasingly, individuals bear less of it, governments more, and I wonder if the sheer inequity of this trend has poisoned our politics. Not many people know that up until the 1935 Banking Act, it was the stockholders who got a capital call if the institution in which they held a fractional interest became impaired or insolvent. Mind you, the stockholders, not the taxpayers. Compare and contrast 2008, when, in effect, the government issued a capital call to the taxpayers. That’s all wrong.
KD: This is collectivism, is it not?
JG: It’s financial collectivism. It’s the nationalization of loss and the privatization of gain. Remind me to fix it when I become president.
An unheralded work on the Austrian business cycle that rivals the work of the greats is Jesús Huerta de Soto’s Money, Bank Credit, and Economic Cycles, which outlines a multistate process of boom and bust.
Original Article: "Jesús Huerta de Soto’s Six Stages of the Austrian Business Cycle: Which Stage Are We in Now?"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
James Grant is editor of Grant’s Interest Rate Observer, which he founded in 1983. He is the author of nine books, including Money of the Mind, The Trouble with Prosperity, John Adams: Party of One, The Forgotten Depression, and more recently Bagehot: The Life and Times of the Greatest Victorian. In 2015 Grant received the prestigious Gerald Loeb Lifetime Achievement Award for excellence in business journalism. James Grant is an associated scholar of the Mises Institute.
Kevin Duffy is principal of Bearing Asset Management, which he cofounded in 2002. The firm manages the Bearing Core Fund, a contrarian, macro-themed hedge fund with a flexible mandate. He earned a BS in civil engineering from Missouri University of Science and Technology and has a passion for financial history, Austrian economics, and pithy quotes. He also publishes a bimonthly investment letter called the Coffee Can Portfolio. Duffy attended Mises University in 1990 after seeing Lew Rockwell on CNN’s Crossfire in 1989.
Kevin Duffy interviewed James Grant for his newsletter Coffee Can Portfolio. It is reprinted with permission.
KEVIN DUFFY: 2020 has been part dystopian fiction, part tulip mania. How do we reconcile the two?
JAMES GRANT: I’m not sure there’s much distinction. To me, the current form of dystopia is the bubble form, so I think this is the year of the dystopian bubble.
KD: There has been a worship of authorities. For the past thirty-seven years you’ve focused mainly on the Fed, but this year we’ve seen a reverence for medical authorities. Who has done more damage?
JG: The medical authorities remind me of the economic authorities. Both pretend to draw a bead on the future. Let’s compare them both to the meteorological authorities. The National Weather Service spends over a billion dollars a year and takes tens of millions, if not billions, of discrete observations of wind, weather, tide, temperature, what have you. But notice the five- and ten-day forecasts on your trusty iPhone are ever changing. This is the weather. Temperature gradients don’t have feelings, they don’t get jealous of the millionaire next door, they don’t watch CNBC, yet our forecasting ability goes out, maximum, ten days. Even so, the economists think nothing of calling next year’s GDP.
KD: This sounds very much like Friedrich Hayek and the pretense of knowledge. There’s a certain hubris taking place. What might the alternative to top-down planning look like?
JG: Counselor is leading the witness! “Pretense of knowledge” is a three-dollar phrase; in Brooklyn it’s called bluffing. Of course knowledge is dispersed. Every individual knows what he or she wants. An economist would say that we know our own demand curves and supply curves. Governor Cuomo can only guess—as brilliant as the governor is—at what we want and what risks we are prepared to run with our lives.
I am seventy-four years old and every day I get out of bed I am beating the odds. The idea of suspending ordinary living pending the arrival of a vaccine is absurd. Still worse is the forced suspension of the lives of people seventy years younger than I. My grandchildren, for instance. “We can’t sacrifice our children out of our own fear,” said Dr. Scott Atlas in so many wise words.
Life is a matter of tradeoffs. And early on people would plague you if you held this view in public by saying, “You mean to tell me that you are willing to trade off profits for human lives?” Well no, I’m willing to trade off risks, and it’s what we all do, whether we realize it or not, whether we can express this or not. We are all, at least subconsciously, living according to our tolerance for risk. We look both ways or no, we don’t look both ways. We scrupulously observe fifty-five miles an hour or we are young and quick and bold and drive seventy-five miles an hour and probably not run a risk to ourselves or others. So people by and large, not exclusively and not entirely, but people by and large know these things about themselves. And what Hayek was driving at is that the Soviet Union failed for a reason.
KD: Let’s take a step back and talk about some of the early influences on you. When did Jim Grant start to become “Jim Grant”?
JG: July 26, 1946.
KD: [Laughter] When did you realize you were an independent thinker? Was there a lightbulb moment or were you just wired that way?
JG: I’ve always been a “yes, but” guy, a skeptic. At Indiana University, I took a course in the history of economic thought. It gave me a sense of the cycle of ideas—how today’s certitudes become tomorrow’s heresies.
Ideas about markets, individual enterprise, individual freedom—they wax and they wane.
Edmund Burke, in his monumental Reflections on the Revolution in France, described English financial arrangements along about 1790. He pointed out that there was no legal tender law in Britain. The only kind of money a creditor had to accept for a debt was gold or silver. Not even the Bank of England could force its notes on the public. Could anything be better, more equitable? Not for me, but notice that system is extinct.
You could say that economic freedom, broadly defined, peaked around 1914, the year following enactment of the income tax and the signing of the Federal Reserve Act.
KD: And the direct election of senators…
JG: Right. And then came World War I, following which (after the 1920s roared) was the war mobilization of the 1930s and 1940s. High taxes, heavy regulation, economic regimentation. But statism, too, has its cycles. The 1947 founding of the Mont Pèlerin Society, a group of old-style liberal thinkers led by Friedrich Hayek, might represent the bottom of the long twentieth-century bear market in economic liberty.
KD: The roots of our monetary meddling go back further, don’t they—even to the Civil War?
JG: Right. It was to fight that war that the Lincoln administration issued the first greenbacks— paper money not convertible on demand into gold or silver. Salmon P. Chase, Lincoln’s Treasury secretary, pushed the greenback plan while holding his nose. He called the legal tender clause “repugnant,” a form of monetary coercion. Later, as chief justice of the United States, he actually judged that clause to be unconstitutional. Subsequent course held otherwise, of course, and the green notes in your wallet today are “legal tender for all debts public and private.” Hardly anyone gives it a thought. Certainly the precedent for what happened in 1913 was set many decades before during the Civil War.
KD: So 1913 brought us the modern incarnation of our central bank, the Federal Reserve. Its first test, from a monetary policy standpoint, was the depression of 1921, which you wrote about in The Forgotten Depression. What was the policy response back then, and how was it different than today?
JG: The policy response was old-time religion. It was monetary and fiscal orthodoxy. President Warren G. Harding inherited a rip-roaring depression in 1921. The roots of that business cycle downturn lay in the wartime inflation of 1914–18. America entered the war in 1917 and proceeded to do what belligerent countries invariably do—to spend more than they earn and to borrow the difference.
The Harding administration balanced the budget—so no fiscal stimulus. Real interest rates were punitively high—there was no QE. Treasury secretary [Andrew W.] Mellon used his influence to reduce those rates. Meanwhile prices fell and wages fell. The stock market was sawed in half. Corporate profits collapsed. Unemployment was then unmeasured, but it soared. But the price mechanism, more or less freely functioning, did its job. Because wages did fall, businesses could regain profitability at lower levels of prices.
The depression of 1920–21 began in inflation, ended in deflation, but it did end: eighteen months from business cycle top to business cycle bottom.
Compare the Hoover administration’s response to the 1929 stock market crash. President Herbert Hoover (he had been Harding’s secretary of commerce) called on business leaders like Henry Ford not to cut wages. And they didn’t, with the result that falling prices, not neutralized by falling wages, devastated corporate earnings, and thus corporate investment. Mass unemployment followed.
KD: The Fed also responded to the slump by injecting money into the financial system by buying government securities. And yet Milton Friedman and others claimed they didn’t do enough.
JG: Yes, that was the lesson according to Milton Friedman and Anna Schwartz. They wrote this big, thick book, always referred to as a magisterial history, A Monetary History of the United States. Its most famous chapter is called “The Great Contraction, 1929–33.” Friedman says the money supply declined by a third, and he thought that that was what put the “great” in “Great Depression.”
Ben Bernanke, you recall, on the occasion of Milton Friedman’s ninetieth birthday apologized to Milton and Anna, saying, “Regarding the Great Depression, you’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
They have not done it again. And they have done everything in their power to ignore the lessons of 1920–21, too. They are all in for interest rate suppression and other such radical nostrums— the “buttinski method.” Do you know what a buttinski is?
KD: No, I don’t.
JG: Somebody who butts in. To them, interest rates are not prices to be discovered in the market, but administered by experts like themselves.
KD: This cycle is perhaps unique in the sense that there is so little price discovery while there are so many price-insensitive buyers, not just the Federal Reserve, but also index fund investors and virtue-signaling millennials. How price insensitive are the banks, and how coerced are their purchases of government bonds?
JG: Well, they need the government securities to fulfill the regulatory requirements for so-called high-quality liquid assets. And yes, central banks are price insensitive, credit insensitive, value insensitive, and they are buyers of corporate debt as well as of government debt and, in some countries, of equities besides.
KD: Why has this so-called “everything bubble” gotten as big as it has? Has that surprised you at all? It certainly has me.
JG: Oh yes. I wake up surprised and go to bed surprised. I mean, consider the $17 trillion plus in securities priced to yield less than nothing. That’s a surprise. It’s a singularity, nothing like it in the entire history of interest rates. Certainly, a financial journalist is privileged to live in this world in which so much is new, so much is to some sense shocking (or gratifying, depending on how you’re positioned).
KD: A friend once said, “It’s okay to forecast the end of the world, just don’t ever give a date.” When people ask you about timing, what do you tell them?
JG: Oh, I’ve become very wily. Years ago, someone asked me to forecast the ten-year yield one year hence, and I had the presence of mind to say no, thank you. I count that as my journalistic coming of age. Only rookies pick levels and dates.
KD: Is it easier to look ten years out? If you take the long view, what do you feel confident in predicting?
JG: I’m fairly confident about the arc of monetary change. Every succeeding crisis brings a more muscular monetary response—a lower funds rate, a larger Fed balance sheet. But ultra-low rates encourage more credit formation, which leads to greater fragility and thus to the next crisis. The Fed is arsonist and fireman all rolled up into one.
KD: Let’s consider a scenario. Let’s say in the next year or so we get a severe global recession which starts to tip over some of these credit dominoes. How might such a scenario play out?
JG: It depends on the nature of the financial crisis. Say it’s an inflationary one. And say that instead of 2 percent inflation, it’s 4 percent or 5 percent. The indicated response would be to raise the federal funds rate, but rivets start popping when money gets tight in a leveraged economy.
KD: So we’re in an inflationary crisis. Let’s face it, the Fed has had a license to print money partially due to Amazon driving prices down. There’s also been a commodity bust. Everything has gone their way. Are you suggesting, in your own words, that “inflation is kryptonite to bonds” and that this is something the Fed does not anticipate?
JG: Well, as a rule, the Fed anticipates nothing. As a rule, most of us anticipate nothing, the future being complex and, for the most part, unpredictable. By the way, the phrase “foreseeable future,” is an oxymoron.
Yes, inflation has been a no-show, though maybe that’s changing. Charles Goodhart and his coauthor Manoj Pradhan, in their fine new book, The Great Demographic Reversal, point out that the past thirty years have delivered a huge positive supply shock. That is, a supply shock in labor. But they contend that, for a number of reasons, the future will be very different, featuring rising inflation and interest rates alike. It’s an impressive and persuasive argument they make.
People my age will no longer be productive, the book says. They will be needful, they will be in the hospital, they will be attended to by their loving aides who will help them either walk or remember, or both. And the dependency ratio [the ratio of those not in the labor force to those in it] is going to rise. So there will be less labor serving and greater demand. And I will add that these will be added to the perhaps inevitable central bank response, which is to be more generous in provisioning the system with money and credit.
So all of this is going to add up to years of inflation, which will shock the bond markets, especially that portion of the bond market, the $17 trillion portion, which is now priced for the certainty—not the risk, mind you, but seemingly the certainty—of either stable prices or gently dwindling prices. What the world is not set up for is an inflation, to be sure.
KD: Just to clarify, you’re talking about labor from China, particularly, and from India…
JG: India, Eastern Europe.
KD: So we’ve gotten the benefits, up front, but these people, as they prosper, will demand more energy, more protein, etc. Are the authors saying the demand side is coming with a lag and that, in turn, adds to inflationary pressures?
JG: Yes. I’m going to read you a paragraph from this book.
It’s China’s “globalisation and the reincorporation of Eastern Europe into the world trading system, together with the demographic forces, the arrival of baby boomers into the labour force and the improvement in the dependency ratio, together with greater women’s employment [that] produced the largest ever, massive positive labour supply shock. The effective labor supply force for the world’s advanced economy trading system more than doubled over those 27 years, from 1991 to 2018.”
But that’s in the bank. It’s behind us. What lies ahead is a deteriorating dependency ratio. More needy people, fewer productive ones, fewer working ones, perhaps more monetary stimulus, and rising prices at the checkout counter rather than falling ones.
KD: In North America, the oil rig count is down 61 percent year-to-date and the natural gas rig count is down 18 percent. So on top of all of this, we’re now getting a commodity supply shock. Is this another tailwind for commodities?
JG: Yes, and you don’t need a big inflation to generate returns. Years of subpar investment in productive capacity in the things that the world needs more of is the essence of the bull case. The key is the supply side.
KD: Socially responsible investing, a.k.a. ESG [environmental, social, and governance], has led to fossil fuel divestment as well. How does ESG enter into the equation for investors?
JG: ESG is a bull-market luxury. In a bear market, people, I think, are much more concerned about survival than they are about making a political statement.
Will Thomson, founder and managing partner of Massif Capital LLC, has a really smart approach to choosing effective ESG-themed investments. Don’t go buying the exchange-traded funds labeled ESG, he says. They own Apple and Microsoft and Facebook and Alphabet. Instead, buy the kind of dirty industrial business that’s cleaning itself up. It makes sense to me.
KD: That’s an interesting arbitrage. Is there a similar opportunity in more accurate accounting? I’m thinking about a company like Tesla, where everyone is focused on the lack of emissions, but they’re overlooking where this electricity is coming from, not to mention the costs of recycling batteries.
JG: I am all for better accounting. And now Tesla’s entering the S&P 500 on the strength of its virtue and flash and momentum and of the tax credits by which alone it achieves profitability. So there’s a singularity of the year 2020 along with $17 trillion in negative-yielding bonds.
KD: You talked about the cyclical nature of markets. Right now youth is elevated. Has the digital revolution made this a young man’s game or is there still room for elder wisdom?
JG: Based upon my experience, there’s no room for elder wisdom.
KD: [Laughter]
JG: Raging bull markets are always young people’s thing. Old guys always say, “I wouldn’t be so quick to pay 170 times revenues for that particular stock. I seem to recall something like this in 1968, or was it 1868?” This is what old people always sound like. Do you remember the author George Goodman? I think his pen name was Adam Smith; he wrote a book called The Money Game.
KD: Oh sure. The go-go ’60s.
JG: If you’re starting a hedge fund, you want young people buying the stocks that are going to go up. Because they don’t know enough not to buy them. People who know enough not to buy them are going to underperform. So in a way it was ever thus. Youth will be served, and youth especially will be served in great raging liquidity-driven bull markets.
Witness bitcoin and the charm and the demonstrated excellence of the FAANG [Facebook, Amazon, Apple, Netflix, Google] stocks. The young people don’t imagine that they have great business models. What they do imagine is that the possibilities for expansion are infinite, whereas the expansion may be limited in the case of Facebook, for example, by such mundane things as the size of the world’s advertising market.
But those objections, the wisdom of the ages, play very badly on the upswing. Again, I think this is nothing new.
KD: Regarding youthful exuberance, I remember the late ’90s tech bubble. On February 15, 2000, 60 Minutes aired a story by Bob Simon called “Dot- Com Kids” where Simon interviewed several young founders of web-based startups that were housed in old buildings in downtown Manhattan, dubbed Silicon Alley. One even told him, essentially, “We’re coming after your job. You’re going to be roadkill.” I guess it didn’t quite turn out that way, did it?
JG: No, but in fairness there’s something to this. There’s something to the displacement of human beings by human ingenuity. It is certainly a fact that technology has improved lives, reduced costs, increased comfort, amused countless millions, and cost some jobs while creating others. That’s the nature of capitalist progress. Capitalist progress is not always to everyone’s aesthetic taste, but it is the ultimate democratic expression of how resources ought to be allocated. The sovereignty of the consumer, whatever the consumer’s taste might be, that’s what will be served.
So young people, whether they can express it just that way or not, do live it. They buy what they themselves like, and what they like often mystifies their elders.
KD: Elders often worry about the next generation. Look at some of the toxic ideology young people have imbibed. How concerned are you? Is there hope?
JG: Oh, of course. I am the father of four and the grandfather of five, and those nine people are fabulous!
KD: That’s the hope! That’s the future.
JG: Right, but everybody else is very questionable.
KD: [Laughter]
JG: Go back to the ’30s and Marxism, without any of the gloss of democratic liberalism, Marxism itself— hammer and claw—was culturally and politically prevalent. And if it wasn’t Marxism, it was the vogue in fascism. We forget that the top tax rate in the Eisenhower years was in the upper ’80s, in fact, into the ’90s. Very few people actually paid that, but that was a legacy of the ideas that reigned, not quite uncontested, but dominated in the ’30s and into the ’40s. That gradually gave way, but don’t forget what happened in the ’60s. There was a Marxist resurgence and then, lo and behold, come the inflationary ’70s, and people find they’ve had enough of that, and then comes Ronald Reagan.
So there’s a cyclicality, there’s an episodic quality to our politics. I don’t think these are end times politically. I think it’s worrying that freedom of speech seems to be back on its heels as much as it has ever been. Freedom of speech, in America, was not quite so endangered even in the ’30s as it is now. That is genuinely frightening. I’m frightened by it.
KD: Rollo May, an American psychiatrist, once said, “The opposite of courage in our society is not cowardice, it is conformity.” It seems like we’re at a point in time when it takes courage to distance oneself from the crowd and from some of these really toxic ideas.
JG: It takes steadfastness, though just how much depends. If you are in a position to lose your job and instead of holding on to that job in the face of ideas and the insistence on ideas you think are wrong, instead of that, you stand up and you object at the risk of losing your livelihood in the case of this master of Eton College in England [he was fired for refusing to withdraw his posted lecture on the virtues of manliness] (and he has five kids)—if you do that, that is courageous.
If you have your own soapbox and you are not really at risk of losing your livelihood, it takes a modicum of bloody mindedness to stand up in front of a mass of opinion. It takes a certain amount of moxie to risk social ostracism. That’s part and parcel of it sometimes, but it doesn’t require a Medal of Honor in that setting. So that’s the distinction I wanted to draw: it depends on how you’re situated in life.
KD: CNBC certainly isn’t the worst of the cancel culture, but nonconformists like Peter Schiff, Marc Faber, and Michael Pento have all been excommunicated. Jim Grant is still there. How have you been able to pull that off?
JG: I’m not sure that the premise of the question is quite correct. I’m on the squawk box every so often, but not very frequently. Take another kind of financial personage. Ed Yardeni is a successful economist. He’s made his living by serving his clients, by trying to make money for them without passing judgment on public policy. Whether the Fed is doing the right thing or the wrong thing is not his remit, he says. His remit, in fact, is not fighting the Fed, but adapting to monetary policy (whatever it is) to make money.
So people like you, like me, like others you mentioned, have chosen a different job description. Grant’s takes a stand on the integrity of the currency. It takes a stand on the nature of markets. It takes a stand on price discovery as opposed to price administration. And we say those things in public and print. We say them on air when given the chance. But they have not lately helped people make money.
CNBC’s viewers—I think most of them—want to know where the markets are going, and if you are not on the right side of that question, you wear out your welcome as a public voice. So I don’t begrudge the producers at CNBC for choosing people with a hot hand.
I am happy, retrospectively, to have been in the wilderness in the early 2000s. Let’s not forget how long they lasted: 2001, ’02, ’03, ’04, ’05, ’06, ’07, yes?
KD: I remember.
JG: If you had had a correct, informed, bearish view on house prices and mortgage-backed securities, you were more than a half decade of wrong before being gloriously right. You have to stick with your guns and have to believe in what you believe and accept that the world can get tired of hearing your foreboding (or, as the case may be, annoyingly bullish) voice.
KD: At a time when other skeptics are routinely dismissed as “the bear crying wolf,” you have somehow managed to stay relevant. The bottom line is you are delivering value. You’re doing a lot more than just bashing the Fed. Grant’s has made some great bullish calls over the years. For example, you saw the economy recovering in 2009 and were bullish on Google fairly early in the bull market, when it was considered a value stock. I would posit that the reason you have this platform is that you’re not just a broken record.
JG: Well, thank you. I am happy to agree with that, and I would credit the fine analysts we have had here over the years. Now, of course, Evan Lorenz is a terrific securities analyst, and, way back when, Dan Gertner—this in 2006 and 2007—did a lot of very early and important securities analysis on complex mortgage structures.
So, yes, thank you. We have indeed earned a voice. I think sometimes, when I get discouraged, that we have earned our reputation a little bit too well of being critics of contemporary monetary arrangements, but I wouldn’t change that. I think that these institutions and these policies are wrongheaded. I think they are dangerous. I think they are possibly even bad for the planet!
It comes down to, Where do you want to make a stand? What matters to you? What matters to me—and to my journalistic lemonade stand—is not saying the correct things to insinuate myself into the good graces of the financial establishment. It’s speaking up against bubbles and the monetary manipulations that inflate them. It’s speaking up for the incredibly outré institutions of the gold standard and for the great institution of corporate solvency (you’d be surprised how controversial it can become at the end of a boom).
That’s the way we’ve run things for a long time. We’ve been in business for thirty-seven years, and that’s the way we intend to keep doing it.
KD: You recently published the “Grant’s Manifesto,” in which you actually tooted your own horn (very unusual), specifically your track record of identifying excesses. Looking at this everything bubble, where do you see the areas of greatest fragility?
JG: To me, the most excessive of all the excesses is these $17 trillion plus of nominal negatively yielding bonds. Nothing like it in four thousand years of interest rate history. They seem to be priced for one outcome alone, the noninflationary one.
Cocksure people baffle me. You run across them all the time on Wall Street, somebody who simply declares, “this is going to happen,” or “that’s going to happen.”
How do you know that? This is a probabilistic world; it’s not a world of certainty.
The great nineteenth-century historian Thomas Babington Macaulay was one of the type. “I wish I was as certain of anything as Tom Macaulay is of everything,” someone said of him. I feel that way with a lot of the Wall Street pundits I read and listen to.
The people who are holding on to these guaranteed- loss securities seem certain of the benevolent path of stable or falling prices. I think by the time Mr. Market puts them through the slicing and dicing machine, there won’t be much left of them.
KD: Will the next banking crisis have sovereign debt at the center of it?
JG: It could. It’s one candidate. Corporate credit is another. With every downward lurch in the stock market, central banks barge in to help. But in helping—with their credit infusions and interest rate slashing—they invite still more lending and borrowing, therefore greater leverage, therefore greater fragility, therefore a greater likelihood that the next financial disturbance will elicit an even greater monetary response, thereby bringing still more leverage, more fragility, etc., and on and on.
KD: Until something breaks.
JG: And maybe that something is going to be the people’s confidence in the central banks.
The central bankers have gotten everyone flummoxed. How would you like to own the stock of a company like the Fed, that did not, shall we say, distinguish itself in 2005, ’06, ’07, ’08, ’09, yet comes out of it with greater power, more prestige…? Now that’s a franchise. My hope is that the next crisis will become also a crisis of belief in central banks and in the judgment of the people who staff them.
One of the big trends of the past century is the socialization of financial risk. Increasingly, individuals bear less of it, governments more, and I wonder if the sheer inequity of this trend has poisoned our politics. Not many people know that up until the 1935 Banking Act, it was the stockholders who got a capital call if the institution in which they held a fractional interest became impaired or insolvent. Mind you, the stockholders, not the taxpayers. Compare and contrast 2008, when, in effect, the government issued a capital call to the taxpayers. That’s all wrong.
KD: This is collectivism, is it not?
JG: It’s financial collectivism. It’s the nationalization of loss and the privatization of gain. Remind me to fix it when I become president.
The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Centuryby Mark ThorntonAuburn, Ala.: Ludwig von Mises Institute, 2018
Michael Novak (michael.c.novak@okstate.edu) is a Ph.D. student in entrepreneurship at Oklahoma State University. He also holds an MBA from the University of Wisconsin-Whitewater.
In Mark Thornton’s The Skyscraper Curse, readers are exposed to the unique phenomenon of the Skyscraper Index and provided with a comprehensive overview of Austrian business cycle theory (ABCT). The Skyscraper Index, as readers learn in the first few pages of the book, shows a correlation between the development of a new tallest building in the world and the business cycle. After exposing readers to the Skyscraper Index, Thornton tactfully explains how the Skyscraper Index exemplifies ABCT, which postulates that policies such as artificially low interest rates, corporate bailouts, and monetary and fiscal stimulus lead to the economic booms and busts that have become a part of modern-day economies. With the world’s next tallest skyscraper, the Jeddah Tower, currently under development, a new skyscraper alert has been issued, and there is not a more timely book to review than The Skyscraper Curse.
In the first two chapters of the book, Thornton outlines all economic crises dating back to 1889 and effectively shows that all of them occurred shortly after a record-breaking skyscraper was built. Andrew Lawrence created the Skyscraper Index in 1999 when he noticed a correlation between the construction of the world’s tallest buildings and the business cycles occurring in the United States (Lawrence 1999). More specifically, the index states that when there is a groundbreaking ceremony for a new record-breaking skyscraper, the economy is booming but that when the building reaches a record-breaking height, an economic crisis follows shortly. This might seem like an unusual phenomenon, but the measure fits all the economic crises of the past century.
In chapter 3, Thornton, explains that the Skyscraper Index not so much about record-breaking buildings being built but rather exemplifies Austrian business cycle theory. Thornton explains how the booms and busts in the economy are caused “when the central bank reduces the market rate of interest below the natural rate of interest by increasing the supply of money and credit” (p. 44). That is, when times are bad, interest rates are typically set artificially low, which increase the ability of entrepreneurs to access funds for investments. This policy resides in Keynesian economics and is how politicians typically deal with economic crises. However, as Thornton proceeds to explain, this is the exact wrong thing to do during economic crises.
In addition to artificially low interest rates, Thornton points to Cantillon effects as playing a major part in the skyscraper phenomena. Richard Cantillon explained how the increase of money in the marketplace has different effects depending on who receives it first (Cantillon 2010). As Thornton explains, if entrepreneurs received the new money first, “the rate of interest would fall, but if the new money came into the hands of consumers that rate of interest would rise” (p. 62). Thornton makes the Cantillon effect’s implications for the development of skyscrapers entirely evident in explaining booms and busts in the economy. When there are periods of deflation and/or interest rates are low, land values increase and long-term projects appear more profitable. In addition, due to lower interest rates, companies are able to grow faster, increase their mergers and acquisitions, and look to expand overseas. As they pertain to developing skyscrapers, artificially low interest rates lead to an increase in land prices, in company sizes, and demand for office space.
The fact that record-breaking skyscrapers are being built does not explain business cycles but rather showcases the underlying reasons for skyscraper developments. When Thornton’s book was published in 2018, the Federal Reserve was keeping the target interest rate below 0.25 percent, which is extremely low based on the history of the Federal Reserve. At the time of this writing (September 2020) the current target interest rate is still below 0.25 percent. With rates this low, developers are encouraged to spend more and save less. As Thornton explains, rational thinking is lost during economic booms as individuals are encouraged to spend due to access to cheap money.
In chapter 8, readers are introduced to the Jeddah Tower, which is scheduled to be the world’s next tallest building. Thornton mentions that a new skyscraper alert was issued on January 1, 2016 (p. 83). In chapter 9, he explains that groundbreaking date for a skyscraper should be considered a skyscraper alert and that the date when the record-breaking height is reached should be considered the “skyscraper signal” that an economic downturn is on the horizon. Thornton suggests that this modified model would have better forecasting power than the original skyscraper index.
In chapter 10, readers learn how land prices increase more in central business districts and how “falling interest rates have an unambiguous effect on higher-wage individuals and land closer to central business districts” (p. 98). The results of lower interest rates encourage people to move closer to central business districts, thereby raising land prices, and causing taller buildings to be built. Chapter 11 takes a unique perspective, illustrating how the Skyscraper Index can be applied at the state level. Thornton shows how the construction of the tallest buildings in Michigan and Arkansas coincided with business cycles. Finally, in chapter 12 Thornton summarizes section one and shifts the direction of the book toward ABCT.
THE AUSTRIAN BUSINESS CYCLE Section two of Thornton’s book is focused on ABCT and how it’s an effective lens through which to view the economy. In chapter 13, readers learn about Mises’s publication “Monetary Stabilization and Cyclical Policy”, written in 1928, which outlined a cause for concern in the market before the Great Depression happened in 1929. By contrasting Mises’s work to the thoughts of mainstream economist Irving Fisher, Thornton produces an early example of an Austrian economist’s success in forecasting economic crises. Mises was one of the first scholars to explain that when the central bank attempts to keep interest rates low to maintain a boom the corresponding crisis becomes worse (Mises [1928] 2006). In chapter 14, readers learn about Keynesian economics and how its policies of monetary expansion focus on measuring economic prosperity through statistics such as gross national product and the unemployment rate. In addition, readers learn that when the US was taken off the gold standard and adopted a fiat money system, the wealth gap continued to grow because a fiat system benefits bankers and people with debt and hurts wage workers and savers (p. 128). Thornton uses the gold standard example to outline how fiat money and central banks tend to help the wealthy, hurt the poor, and increase the wage gap.
Chapter 15 introduces readers to Murray Rothbard and his groundbreaking work on ABCT in the 1960s and 1970s and to F. A. Hayek’s work on business cycle theory that led him to win the Nobel Prize in economics in 1974. Most importantly, Thornton explains how the Ludwig von Mises Institute was founded in 1982 with the premier mission “to educate people about the benefits of a true gold standard as described in the Gold Commission’s minority report” (p. 135). In chapter 17 readers are provided with a comprehensive summary of lead economists’ forecasts prior to the technology bust of 2001, with a clear pattern coming to light: many of the correct forecasts were made by scholars from the Austrian school and focused on the Federal Reserve’s tendency to follow a loose monetary policy of keeping rates below what they would have been otherwise. Also, at the core of correct predictions on the business cycle are the Cantillon effects and more specifically how increasing the money supply changes relative prices.
One of the areas where price changes have been especially prevalent in business cycles is housing prices. Chapters 19, 20, and 21 expose readers to the Federal Reserve’s role in the housing bubble and how the artificially low interest rates set by the Federal Reserve drove renters to become buyers and led to price inflation. Thornton does a great job of explaining to readers how the Chicago school essentially denies the existence of market bubbles and how the Keynesians believe that bubbles are due to psychological factors. Keynesians also see business cycles as an “ebb and flow of mass consciousness and emotions” (p. 189). In contrast to the Chicago school and Keynesianism, Austrians believe that both real and psychological factors play a role in financial bubbles but that the cause of bubbles ultimately comes back to the policies of the Federal Reserve. According to the Austrians, when new money is introduced in the money supply and directed toward specific industries, bubbles develop. Thornton goes as far as to suggest that if the Fed would not intervene in the economy through loose monetary policy, bubbles would not develop. In addition, the bubble is not the issue but rather the Federal Reserve System, which allows booms to flourish and become unsustainable, something that has been echoed by Murry N. Rothbard (1972). Thornton shows how misallocations of resources to an industry develop under artificially low rates and how the bubble pops when that irrational allocation becomes too great to bear.
In the closing chapters Thornton explains how depressions begin with a period of monetary expansion followed by a crisis. Depressions are prolonged by government intervention through policies that are used to reverse economic crisis. Readers also learn that many Austrians believe that during a depression the government should take an active role in reducing the size of the government and balancing the budget but a passive role in economic policy to allow the economy to recover as naturally as it can. Naturally is used lightly, as the government intervention that people experience in the economy through the actions of the Federal Reserve makes it impossible to understand what would happen in the absence of intervention. A laissez-faire approach would make the corrective process during a depression faster and bring an economy out of despair more quickly.
DISCUSSION AND CONCLUSION At the end of the book readers are reminded of three main causes of economic malaise in the US—a large debt accumulation, a personal savings rate that has fallen dramatically, and a continued increase in regulatory burdens on the economy. According to Thornton, if the US is to overcome its current economic flaws, the US needs to disband the Federal Open Market Committee, shut down the Federal Reserve, cancel the Fed’s holdings of government bonds, eliminate taxes on capital gains of gold, silver, and new money (e.g., cryptocurrency), repeal legal tender laws, and eliminate federal insurance of demand deposits. Thornton acknowledges this is a lot to do at once and would likely cause a painful adjustment process throughout the economy. Therefore, he proposes that the US start with dismantling the Federal Open Market Committee and allowing interest rates to be determined on the open market.
Thornton’s comments on the role of the Federal Reserve in the economy are not supportive of the institution by any means, but his arguments make it hard for mainstream economists to refute his stance. In the first part of the book, he makes it clear that although the Skyscraper Index does have a track record of correlating the construction of the world’s tallest buildings with business cycles, the skyscrapers are not the heart of the matter but rather the fiscal policies of the Federal Reserve that promote and encourage skyscraper development. In an earlier article, Thornton mentioned that it is possible that the Skyscraper Index could become obsolete in the future (Thornton 2005). However, even if the index does become obsolete, it does not change Thornton’s arguments about the Federal Reserve’s role in the business cycle.
Although the arguments outlined in The Skyscraper Curse are adequate for the purpose of explaining the role of the Skyscraper Index and the ability of ABCT to predict economic crises, one area that could have used further development was the explanation on how the true issue with economic crises is not the bust but rather the actions taken by the Federal Reserve during the boom. Thornton outlines numerous times how fiscal policies set by the Federal Reserve lead to economic crisis, but it is never deeply elaborated on. Rothbard (1963) made it clear to readers that during times of economic expansion, the Federal Reserve sets policies that prolong economic booms (e.g., supporting credit expansion and lowering interest rates) and make the recovery from the corresponding busts longer. Had Thornton offered more commentary on the boom, it would have made his arguments on how the US can overcome its current economic issues more compelling.
In summary, The Skyscraper Curse exposes the Skyscraper Index, which has predicted every economic crisis since 1889 and complies with ABCT, but the book is more about ABCT and exposing readers to the drawbacks of a Federal Reserve with a loose monetary policy. With the recent events of COVID-19 and the Federal Reserve’s response of lower interest rates, corporate bailouts, and individual stimulus payments, one may expect that an economic downturn is on the horizon. Mark Thornton’s book is a timely review of Austrian business cycle theory and I encourage all to read it so that they can be prepared for the next economic downturn.
For the LP Mises Caucus, Bob received a slew of questions to be answered in a half hour. The topics range from business cycle to free trade to a "voluntary" State.
Mentioned in the Episode and Other Links of Interest: The YouTube version of this episode. For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Download the slides from this lecture at Mises.org/MU20_PPT_13.
Recorded at the Mises Institute in Auburn, Alabama, on 14 July 2020.
Thanks to past interventions, the economy is now rife with malinvestments and prices that don't reflect real demand. The solution is to allow deflation and other types of painful readjustment. Otherwise true growth will elude us.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "How Government Intervention Triggers Depressions"
Abstract: Since Samuelson’s (1966) reswitching example in the 1960s, it became clear that the Average Production Period (APP) is not necessarily a decreasing function of the interest rate. Recently, Fillieule (2007) and Hülsmann (2010) have shown that Samuelson’s example is not a mere curiosity. They showed that in a reasonable production structure model, the length of production increases with the interest rate instead of decreasing. However, their model did not present “reswitching” behavior. In this paper a generic model of the structure of production, in which both Fillieule’s and Hülsmann’s models are specific cases, is presented. It shows that the APP has a nonmonotonic dependence on the interest rate, which resembles a “reswitching” behavior: it increases for low-interest rates up to a maximum value, and then decreases back to almost the initial value. The decrease occurs within a relatively narrow range of interest rates, which may explain why it was missed in the literature.
business cycle — interest rate — structure of production — austrian economics — reswitchingJEL Classification: B53, E43, L11, L16, D24, B25, L23
Er’el Granot (erel@ariel.ac.il) is a professor at the Department of Electrical and Electronics Engineering, Ariel University, Israel.
INTRODUCTION Recently, there has been a revival in the interest in the reswitching debate. The debate is part of the Cambridge capital debate, which took place during the 1960s and 1970s (Harcourt 1972, 1976; Cohen and Harcourt 2003). While the capital debate did not end with a clear conclusion, Samuelson (1966) used a nice pedagogical example to illustrate the problem, in what was considered to be one of the main pillars of economics. One of the conclusions of Böhm-Bawerk’s intratemporal studies was that the players’ time preference determines the pure rate of interest (PRI), and therefore when the PRI decreases the entrepreneur seeks more productive roundabout production processes (Böhm-Bawerk 1959). Consequently, it seems that the natural conclusion is that when the PRI decreases, the structure of production lengthens.
This conclusion affected not only the neo-classical school but significantly influenced the Austrian school of thought. Hayek (1933, 1935) developed Jevons’s structure of production and Böhm-Bawerk’s analysis in his business cycle studies. Rothbard (2008) developed Hayek’s treatment by integrating the interest rate in the structure of production. The general structure appears in more modern writings.See, e.g., Skousen (1990), de Soto (2006).
The reswitching debate did not have a considerable impact on the Austrian school, probably because it was not regarded initially as more than a mere curiosity. Moreover, it is true (see Murphy [2003]) that the validity of reswitching does not fundamentally contradict Böhm-Bawerk’s claim that the entrepreneurs’ time-preferences is directly related to their willingness to lengthen or to shorten the production process. In fact, the reswitching effect does not contradict any fundamental praxeological law. However, does it affect the structure of production?
Fillieule (2007) constructed a simple model for the structure of production. In his model the structure of production consists of infinite stages of production, i.e., the structure of production begins at the dawn of humanity. Moreover, it was taken that in every stage the ratio between the amount of money invested in original factors of production (labor and land) and the amount of money invested in capital goods is a given constant ratio.
Under these fundamental propositions, the structure of production has an exponential shape. That is, the structure of production decays exponentially the higher one goes in the production’s stages, since the ratio between the amounts of investment in adjacent stages is fixed. An example of such a production structure is illustrated in Fig. 1.
Figure 1.
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Due to the fixed ratio between adjacent stages of production, the calculation is relatively simple and straightforward. In this case, the Average Production Period (APP) was found to be (Fillieule 2007)
(1)
where λ is the APP, I stands for total investment, C is the amount of consumption and r is the interest rate per stage of production.
It should be noted that in the literature the stages are usually numbered by positive numbers, however, to be consistent with the fact that stage 0 is the final stage, I chose to present them as negative numbers. This notation is also consistent with the terminology: “1st stage of production”, “2nd stage of production” etc. 1st cannot correspond to 9, but it may correspond to -9.
Hülsmann (2011) took a similar approach, but with several differences, which have to be stressed. In Hülsmann’s production structure model, there is a finite number of production stages. Furthermore, it is assumed that capitalists pay for original factors of productions (land and labor) only at the beginning of the production process. In the intermediate production stages, capitalists pay only for capital goods plus interest. Furthermore, his research focuses on a low interest rate, in which case the structure of production has a trapezoidal shape (as in Hayek’s model). An example of such a production structure is presented in Fig. 2 (again, one can see that I use negative numbers to represent the stages of production because production takes place in the present).
To simplify the discussion, Hülsmann (2011) did not present a formula, and instead, numerical results were presented. However, straightforward derivation reveals that in the low interest regime (the most relevant one, and the one which creates the trapezoidal shape), the dependence of the number of production stages (N) on the interest rate (r) is (see Eq. 6 in Appendix A)
(2)
Figure 2.
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A more accurate derivation, which is valid for 0 < r < C/I, shows that (these expressions do not appear in the original paper, but are derived in Appendix A as Eqs. A5 and A6).
(3)
Both the numerator and denominator of Eq. 3 increase with the interest rate, however, since in the numerator r is multiplied by a larger numberIC 1 then the number of stages is an increasing function of the interest rate. Moreover, as r increases and tends toward CI from below, then the number of stages diverges, i.e., N—> ∞.
Therefore, we recognize that in both models the length of production (LOP) increases with the interest rate, which, as was emphasized by Hülsmann, is in clear contrast to the Austrian understanding of the structure of production.
Machaj (2015, 2017) tried to solve the inconsistency between these results and the Austrian literature by emphasizing the importance of the Intertemporal Labor Intensity (ILI) in the production’s structure. According to this terminology, ILI indicates the amount of money being spent on original factors of production in the earlier stages of production relative to the later stages.
High ILI corresponds to the case where most wage payments, i.e. labor investment, are concentrated in the early stages of the production process. Low ILI corresponds to the opposite case, where most wages are paid in the last stages of production. Machaj does not quantify the relation between the ILI and the correlation between the LOP and the interest rate; however, it seems that he relates low ILI with negative correlation and high ILI with a positive one. This tool helps him to explain the positive correlation between the LOP and the interest rate in Hülsmann’s and Fillieule’s model, since, according to him, in both models the ILI is high (see Machaj [2017, 78]).
Clearly, the ILI has an important impact on the structure of production. However, how can it explain the inconsistency between the Austrian literature and the results of Hülsmann and Fillieule? After all, contrary to Machaj’s claim, the ILI is completely different in the two models.
In Hülsmann’s case, the ILI is clearly high (since labor is invested only in the first stage of production). However, in Fillieule’s model, most of the labor investment is concentrated in the last stages of production (after all, there are infinitely many stages, but the labor investment increases exponentially), and therefore the ILI is definitely low, regardless of the interest rate.
Nevertheless, both models present a positive correlation between the LOP and the interest rate (provided the ratio between investment and consumption is fixed).
Therefore, knowing the ILI is insufficient to determine whether the LOP increases or decreases as a function of the interest rate.
Moreover, the ILI is not a well-defined quantity. If ILI is a measure of the average period of labor investment, then it is almost identical to the Böhm-Bawerkian definition of the APP. Then it is clear that the APP is low whenever the ILI is low and vice versa. Therefore, the ILI does not add information to the question about whether the APP will increase or not; the ILI is the solution to this question. But, as we will see below, the situation is even more complicated than that.
Hülsmann emphasized that it is not surprising that in both models the same positive tendency appears, i.e., LOP increases with interest rate, because, according to him, they basically followed the same methodology. However, a close inspection reveals major differences.
Nevertheless, despite the differences between the two models, they are, basically, two specific cases in a more generic one.
CONSTRUCTING THE GENERIC MODEL The generic model, is the case where there is a finite number of production stages N (like Hülsmann’s, Hayek’s and Rothbard’s models), but in every production stage the investment consists of capital investment, whose fraction is (1-a), investment in original factors (OF), whose fraction is a (as in Fillieule’s model) and interest fraction r (it should be noted that only when the time period of a single stage is one year does r stand for the annual interest rate). Mathematically, it means that the amount of money capitalists spend in the -nth stage is I-n and the consumption at the final stage (stage zero) is equal to c, i.e.,
(4)
In the first production stage of high-level goods, the investment is equal to
(5)
In general, the expenditure on OF of production at the nth stage of production is
(6)
that is, in the intermediate states only a fraction a out of the entire investment is dedicated to OF, while in the first production stage all investment is directed to it.
Therefore, the investment in capital products at the -nth stage of production is
(7)
(note that we adopted Fillieule’s notations except for the stages’ numeration).
Consequently, the relation between the investments in adjacent stages is (for 2 ≤ n ≤ N)
(8)
The structure of production of this generic model is presented in Fig. 3.
Figure 3.
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This is a generic model: Hülsmann’s model is a specific case, which can be derived by taking the limit of zero expenditure on original factors, i.e. a —> 0, while keeping the number of production stages finite, i.e., N < ∞. Fillieule’s model can be reconstructed by keeping a constant percentage of the expenses on original factors, i.e., a > 0, but taking an infinite number of stages, i.e. N —> ∞. In both models, the interest rate is taken to be non-zero, i.e., r > 0. It should be noted in passing, that the generic model encompasses a third kind of structure, which is reminiscent of Hayek’s (1935) model of the structure of production in that it does not take the interest payments into account, i.e., r = 0. However, it is not the same kind of structure because Hayek’s structure is linear, while the generic model is exponential.
Now, since the LOP in both models (Eqs. 1 and 2) is independent of a we find a problem. Nevertheless, before we explain the problem, we must emphasize again the point that r in our model (as in Fillieule’s and Hülsmann’s) is not the annual interest rate, but rather the interest rate paid in a single production stage. Therefore, if one chooses very short production stages (in the possible range), r can be arbitrarily small regardless of the interest rate (note that the ratio I/C is independent of the length of the stages). In this limit, Fillieule’s result reveals only a negligible dependence on the interest rate.
In fact, if one follows Fillieule’s derivation with a single difference: omitting the interest rate at the last stage of production, the prefactor (1+r) vanishes, i.e., λ = I/C. Therefore, the dependence on the interest rate (1+r) is a result of the last stage and has nothing to do with the entire (infinitely long) structure of production.
If the number of production stages is finite, then it is clear that in the limit of low interest rate rN << 1 Hülsmann’s model is retrieved, because then Hülsmann’s trapezoid shape appears. However, in the limit of high-interest rate rN >> 1, Fillieule’s model is retrieved, since in these cases the amount of investment in the early stages (n > 1/r ) is minuscule, and therefore for any practical purposes N can go to infinity without affecting the distribution of investment.
Consequently, the parameter which determines in which domains we are is the product Nr. If Nr >> 1 then the model enters Fillieule regime (the production structure is approximately exponential), while when Nr << 1 the model enters Hülsmann’s domain (the production structure is approximately trapezoidal). Clearly, however, our model is richer than the two independent regimes.
Now, we can turn to and explain the problem:
When the interest rate is low, then the APP can be approximated by Eq. 2, i.e. , however, since I/C > 1 then . However, , as was explained above, should be valid for higher interest rates, when the number of stages diverges. Therefore, for any given interest rate, Hülsmann’s model APP is higher than Fillieule’s, which means that eventually, the APP must decrease. Below we will present this behavior in detail.
The inevitable conclusion is that the two formulae do not present the same reality, and not even the same tendency. In fact, these results show that for low interest rates, the LOP increases with the interest rate, while for high interest rates the LOP must decrease. The mathematical proof for this will be presented below.
There is no monotonic dependence on the interest rate. Therefore, not only do these models contradict the Austrian and neo-classical literature, but a reswitching >musteventually occur. Reswitching is, then, not an anomaly or a mere curiosity, but it is the norm (provided the ratio between consumption and investment is fixed).
It should be stressed, however, that this “reswitching” is not equivalent to Samuelson’s original one. This is because the reswitching does not occur between two different production methods, but rather a reswitching occurs in the sense that for low interest rates the production structure is short; when the interest rate increases the structure of production lengthens. However, it shrinks again when the interest rate keeps increasing.
One of the reasons that this unexpected conduct was overlooked is that there are inconsistencies in the definitions of the LOP.
In what follows, we will solve this model analytically, and present the reswitching result. However, before we do that, we have to clear up the confusion regarding the definition of the LOP.
Jevons, Hayek, Rothbard, and Hülsmann identified the LOP with the number of production stages. When the number of stages is low, i.e., when N(α+r) << 1, the number of stages is indeed a very good estimation to the LOP. However, when the number of stages increases, the amount of money invested in the early stages of production, i.e., where higher-level goods are produced, is small in comparison to the aggregate investment. Therefore, the contribution of these stages to the LOP is negligible. Clearly, when the number of stages is infinite, i.e., when the production process begins at the dawn of humanity (as in Fillieule’s model), it is clear that the number of stages is an inadequate evaluation of the LOP.
It should be stressed that taking the production stages to infinity is not merely an academic exercise. In fact, as was stressed by Machaj (2017), any modern production process begins with capital goods. It is almost impossible to reconstruct a production process that does not require capital goods in its initial production stage. Therefore, an infinite number of stages does not seem to be the exception, but rather seems to be the norm, and should not be disregarded.
Ironically, it seems that Böhm-Bawerk has realized this problem, and used the average period of production, which is defined as the “average time interval occurring between each expenditure of originary productive forces and the final completion of the ultimate consumption good.” Therefore, instead of using the ambiguous term LOP, we would use the more clearly defined term “average period of production” (APP). This term can easily be implemented in all three models by
(9)
where Ln is the amount of money invested in labor during the nth stage of production, while
(10)
is the aggregate investment in original factors (labor and land).
Hereinafter we will adopt Fillieule’s assumption that in the intermediate stages all the investment on OF consists of labor’s salaries. This is a reasonable assumption because it is very rare that the industries utilize unprocessed OF, i.e. non-capital goods, during intermediate stages of production. Moreover, it is not a restrictive assumption, and the model can easily be generalized.
CALCULATION OF THE APP From Eqs. 5 and 8, the investment in the nth stage can easily be calculated:
(11)
for n ≥ 1, where, for simplicity, the following notation was used
(12) .
Then, aggregate saving is (see Appendix A)
(14)
Similarly, the aggregate income of owners of OF is
(15)
where
(16) ,
are the incomes of owners of OF in the -nth stage, which is a manifestation of the fact that in the Nth production stage all money is invested in OF, while in the intermediate stages only part (a) of the money is invested in them.
Similarly, the aggregate income of owners of capital goods is equal to
(17) .
Using Eq. 9 the APP is (see Appendix A)
(18)
which can be solved as
(19)
The dependence of the APP on the interest rate is via the auxiliary parameter q.
According to Eq. 19 when the parameters a and N are fixed then λ (the APP) decreases when the interest rate r increases. However, when the interest rate varies, so does the aggregate investment I (according to Eq. 14).
In order to keep the aggregate investment fixed, the number of stages of production N must increase accordingly. Therefore, in order to keep the ratio between consumption and investment fixed, one can substitute the number of stages N from Eq. 14 into Eq. 19, i.e., to substitute
(20)
in the expression for λ, (note that Eq. 3 is a specific case when a=0). But before we do it, it is useful to adopt the following definition of the critical interest rate
(21) .
Using this terminology, the number of production stages, i.e., Eq. 20, can be written
(22) .
which clearly diverges when r —> rc.
By substituting Eqs. 12, 21, and 22 in Eq. 19 the APP can finally be written as (see Appendix B for elaboration)
(23)
When a —> 0 then λ —> N, i.e., the APP converges to the number of stages. In fact, as long asr << rc and a << r then λ ≅ N (see Eq. B2 in Appendix B), i.e., in this case, the number of production stages is indeed a good approximation of the APP. This is the interest rate regime, which was investigated by Hülsmann.
However, as the interest rate approaches the critical interest rate, i.e., r ≅ rc, then the number of stages N diverges, while the APP, i.e. λ, does not (see Fig. 4). In fact, the APP finally decreases and converges to (note that all the terms (rc-r) in Eq. 23 vanish)
(24)
which is exactly Fillieule’s (2007) result for r ≅ rc .
In context of the generic model, which is presented in this paper, we see that Hülsmann and Fillieule investigated different regimes of the interest rate. Hülsmann’s model agrees with the generic model at the low interest rate regime, while Fillieule’s model agrees with the generic model only around r ≅ rc, where the number of stages diverges.
As can be seen from Fig. 4, there is an interest rate level r, below which the APP increases, and above which the APP decreases. This is the point where APP receives its maximum value λmax = λ(r) (see Fig. 4).
Figure 4.
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In Fig. 5, the APP as a function of a and r is presented in a contour plot. As can be seen, for any given 0 < a < C/I there is an interest rate, which is lower than the critical one, in which the APP receives its maximum value, and above which it decreases to almost the initial value.
Figure 5.
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This maximum effect is especially noticeable when the fraction of OF’s investment is very low, i.e., a << 1 (For details, see Appendix C).
This “reswitching” phenomenon occurs due to the following reasons. In the low interest rate regime, any increase in the interest rate forces the APP to expand in order to compensate for the reduction in the high-level stages of investment. However, this process cannot last for long, since when the interest rate increases beyond a certain level (r*), the reduction in the low stages’ investment reduces the APP beyond the increase caused by the additional stages. Thus, in this regime, the APP decreases. Beyond the critical interest rate (rc) the reduction in the low stages’ investment cannot be compensated by the negligible investment in the high stages of production.
It should be emphasized that when r < rc the interest rate can increase while both I/C and a are fixed, because the number of stages can increase. However, beyond rc, since the number of stages is already infinite, it is impossible to raise the interest rate without affecting either a or I/C. In this regime, if the ratio I/C is fixed, then λ = (I/C)(1+r) (Eq. 1), in which case the APP mildly increases with the interest rate (see the dashed curve in Fig. 6). However, if a is fixed, then APP obeys the equation λ = (1+r)/(r+a) (see Fillieule [2007]), in which case the APP decreases with the interest rate (see the solid curve in Fig. 6).
Figure 6.
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A further important and original result is, that the APP does not have a simple monotonic decreasing dependence on the ratio between consumption and investment (as wrongly predicted in the literature, see, for example, Chapter 8 in Murphy [2006]). If the fraction a and the interest rate r are fixed, the APP initially increases with the ratio (C/I), and only after receiving its maximum value, it begins to decrease (as N does); see Fig. 7.
Figure 7.
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In countries like the United States where C/I ≈ 0.5 (see Skousen [1991, 45]) the difference between rc ≡ C/I a, and r (the interest rate with the longest APP) is very small (see Fig. 8 where r was calculated numerically).
Figure 8.
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This fact can explain why this “reswitching” was missed in the literature, and how it became common knowledge that the APP must decrease when the interest rate increases.
SUMMARY AND CONCLUSION A generic model of the structure of production was presented and studied. Hülsmann’s and Fillieule’s models are two limiting cases of the generic model. The low interest regime of the generic model can be approximated by Hülsmann’s model, while the high interest regime of the generic model can be approximated by Fillieule’s model.
Thus, the generic model leads to a result that is different both from the older Austrian literature and from the recent one.
Therefore, this model predicts that when the interest rate increases, the APP does not decrease as the neo-classical models (and the old Austrian literature) predict. Moreover, the APP does not increase as the new Austrian models predict.
In fact, the main prediction is that when the ratio between consumption and investment is fixed, the APP increases for low interest rates, but beyond a certain value, it decreases.
This conduct resembles a “reswitching” behavior when the APP is low for both low and high interest rates, but it grows for intermediate interest rate levels.
However, this conduct can occur only if the ratio between consumption and investment (C/I) and a are both fixed, which is possible to maintain only within a narrow range of interest rate values. Whenever the interest rate exceeds this range, at least one of these parameters, either (C/I) or a, must vary as well. If the former (C/I) is fixed, then the recent Austrian prediction holds, but when the latter (a) is fixed, then the older Austrian prediction is valid.
American Bonds: How Credit Markets Shaped a NationSarah L. QuinnPrinceton, N.J.: Princeton University Press, 2019289 pp.
Patrick Newman (patrick.newm1@gmail.com) is assistant professor of economics at Florida Southern College and a fellow of its Center for Free Enterprise. He is also a fellow of the Mises Institute.
This is a frustrating book. Quinn’s American Bonds shows that the federal government’s credit policies were important factors behind the particular evolution of securitization and credit markets in the United States. Quinn’s historical narrative, from the country’s founding to the present day, is intertwined with a brief overview of important business cycles and economic crises that affected credit markets, such as the Panic of 1819 and the 2008 financial crisis. Although Quinn investigates how federal legislation and institutions were important in facilitating the intermediation of credit in various markets, including in land, railroads, and mortgages, she completely omits an analysis of the policies’ efficiency. She also fails to contribute to our understanding of whether the government was necessary for the formation and development of these particular markets or if private actors could have provided similar financial specialization in the absence of government involvement. In the end, American Bonds merely provides a historical overview of credit markets without seriously investigating whether the government’s intervention was indispensable or weighing the costs and benefits of its involvement.
The main problem of the book is its theoretical framework. According to Quinn markets cannot function, let alone exist, without significant government assistance and intervention. Moreover, misguided government intervention does not promote inefficiency or economic recessions, because without government involvement the outcome would have been even worse. In fact, laissez-faire is “a utopian dream,” and “attempts to move into a laissez-faire world would mean deregulation, which inevitably causes instability, crisis, and human suffering, leading people to demand protection from the government” (p. 203). Although Quinn argues that free markets are an illusion, quite astonishingly this does not stop her from describing various financial markets as “laissez-faire” because they lack (or purportedly lack) direct government oversight. Quinn naturally leaves out the indirect oversight of those financial markets, such as the Federal Reserve’s regulation of the banking system and its ability to inject credit into financial markets. Although Quinn utilizes the theories of Hyman Minsky and recognizes that “all bubbles depend on credit expansion,” expansionary monetary policy is surprisingly absent from the list of potential culprits in the start a boom (p. 27). Whenever the government does clearly contribute to a financial crisis, the escape hatch is that the unfettered market would have been much worse, so that in reality the government did nothing wrong. Quinn succinctly states her view when she discusses the recent 2008 financial crisis and the government’s decades-long involvement in securitization of mortgages and cheap credit policies:
Does this all mean that the federal government is to blame for the crisis? After all…the government played a central role in keeping credit cheap, and cheap credit fueled the crisis. While it is a fair question, I nevertheless worry that it is a misleading one. It is obviously bad policy for a government to hit the accelerator on financial markets while also removing the brakes. Aside from the issue of whether this question deflects responsibility from Wall Street…it carries the unspoken assumption of a world where advanced capitalist markets somehow exist without extensive government participation….the real problem was not regulation but overzealous deregulation. (p. 210)
Quinn’s theory of markets and the indispensable nature of state assistance allows her to sidestep investigating the efficiency and possible adverse consequences of government policies. Thus, Quinn is able to write about the development of land sales on credit without questioning whether it was an important factor behind the land speculation that led to the Panic of 1819. More importantly, Quinn fails to discuss how the government’s suspension of specie payments from 1814 through the post–War of 1812 era (with only nominal resumption in 1817) and the newly created Second Bank of the United States (established in 1816) were important factors in facilitating an increase in the money supply and a postwar boom. A similar lack of analysis is shown in Quinn’s section on federal assistance to railroads in the post–Civil War era, because she does not link the generous loan and land assistance with the transportation companies’ inefficiency and corruption (pp. 23–36).
Most aggravating are her overviews of the development of credit markets in the early twentieth century. Quinn champions the Federal Farm Loan Act of 1916, which established a system of land banks to lend to farmers. She documents the Treasury’s subsequent assistance and describes how the banks had lent roughly $350 million by the end of 1920. However, she does not link these actions at all with the difficulties that farmers experienced in the post–World War I era (pp. 82, 86–87). Could the new legislation, in addition to the European demand for US agricultural products during the war, have encouraged an overexpansion of farming and then delayed recovery by subsidizing agriculture after it was no longer needed in such large amounts? Quinn provides no answer. Quinn also neglects how other misguided government regulation in the housing market around this time gave a superficial indispensability to federal assistance. She recognizes that during the Progressive Era housing reformers advocated new construction codes that were important factors in driving up building costs beyond the increase in consumer prices, as well as how the war increased the profitability of manufacturing relative to the real estate market and led to rent controls and prohibitions on the construction of houses. However, Quinn then documents the government’s subsidization of home construction through the Army’s Ordinance Department, the Emergency Fleet Corporation, and the United States Housing Corporation without ever raising the possibility that the government created the crisis that the public and intellectuals came to believe only it could solve (pp. 92–93, 99–103). Instead, “the defenders of laissez-faire had good reasons to be worried,” because there was a clear need for the government to step into the breach (p. 103).
Overall, although this book provides important empirical information on the development of credit markets and various related government programs, it lacks a serious theoretical and interpretative framework.
Narrative Economics: How Stories Go Viral and Drive Major Economic EventsRobert J. ShillerPrinceton: Princeton University Press, 2019xxi + 377 pp.
Abstract: Much of Shiller’s new book is about how economic narratives form, spread, and fade. Drawing on medical evidence about the spread of infectious disease, Shiller argues that “economic fluctuations are substantially driven by contagion of oversimplified and easily transmitted variants of economic narratives.” But Shiller ignores the powerful role of monetary disorder, whether in forming the narrative or determining the contagion rate, or as a competitor to the narrative. Ignoring or downplaying money’s role leaves Narrative Economics a disappointment.
recession — housing bubble —monetary policy — narrative economics — business cycle
Brendan Brown (monetaryscenario@outlook.com) is a nonresident senior fellow at the Hudson Institute and an associated scholar of the Mises Institute.
Robert J. Shiller in his new book focuses on an issue of fundamental importance to understanding economic and financial market cycles—the rise and fall of narratives. The book is full of promise, written by an author acclaimed for his pioneering work in applying psychology research about impaired mental processes in decision-making to economic and financial market analysis.
A well-known proposition of modern psychology, termed the representativeness heuristic by authors Daniel Kahneman and Amos Tversky (1973), is that people form their expectations based on the prominence of an idealized narrative rather than estimated probabilities. Shiller gives the example that we judge the danger of an emerging economic crisis by its similarity to a remembered story of a previous crisis rather than by any logic.
Much of this book is about how economic narratives form, spread, and eventually fade. But there is an aim beyond that. In Shiller’s own words, “A key proposition of this book is that economic fluctuations are substantially driven by contagion of oversimplified and easily transmitted variants of economic narratives.” He draws on medical evidence about the spread of infectious diseases to develop his thesis.
The speed and extent with which a narrative penetrates a population (for example of global investors) is determined by the contagion rate relative to the recovery rate. The latter in this context means forgetting or losing interest in the presumed facts disproving the narrative. The contagion rate can be greatly lifted by the endorsement of a celebrity (who may in some cases be its originator).
There is much in the book about the narratives that form in various asset markets. Given Shiller’s renowned research into the housing market, the reader will likely be drawn to his analysis here. The author identifies price index publication as a trigger to narrative creation. According to Shiller, the start of data agglomeration on stock market indices triggered greater contagion and the origination of narratives about equities from the 1930s onward, and he attributes the same role to the Case-Shiller data on US housing prices from the 1990s. Indices and their movement become a trigger to regular storytelling by journalists.
Shiller concludes that narrative economics should have a key role in economic theory. To understand both secular and cyclical developments, we must identify the economic narratives that are powerful and active contemporarily, and how they are waxing or waning. Collecting better information about changing narratives should begin now. Shiller does not suggest that this is a simple endeavor. Narratives mutate, recur, and are often complex. Optimistically, though, he asserts that economic research is already on its way to finding better quantitative methods to understanding narratives’ impact on the economy.
Unfortunately, the author’s citation of narratives that have played key roles in past economic and financial outcomes is far from convincing. And there is an elephant in the room that the author ignores totally—the powerful role of monetary disorder, whether in forming the narrative or determining its contagion rate, or as a competitor to the narrative in providing an explanation for economic and financial fluctuations. Shiller’s focus on disease epidemiology and his ignoring or downplaying of money’s role leaves readers questioning his propositions in two ways.
First, surely there are powerful groups in the political economy whose purposes the spread of a narrative serves well. These groups, whether business or political, out of self-interest might apply propaganda techniques to help a narrative spread. For example, we can think of monopolists in search of a narrative to justify their huge actual or potential profits. Similarly, the promoters of highly valued new enterprises (the so-called unicorns) in Silicon Valley may be delighted that a narrative is going viral in which their innovation will be the new road to El Dorado. A narrative in which digitalization forms the basis of a third industrial revolution, analogous to steam power in the first one or electricity in the second, could suit both fine groups fine.
Second, monetary inflation’s impairs normal rational skepticism in the marketplace and thereby might give a major fillip to the contagion power of certain narratives. Yet Shiller makes no mention of this possibility. That is odd, especially in the context of the present cycle, during which central banks have been pursuing radical experimentation, meaning that investors are faced with negative returns on money and government bonds. A hunger for yield becomes evident among interest income famine investors. This desperation and its corollary—susceptibility to speculative storytelling—are consistent with the psychological evidence behind prospect theory (see Kahneman 2011). According to this theorem, if someone is presented with a choice between a certain loss or a bad bet with some chance of gain, and whose actuarial value is greater than the certain loss, he or she will take the gamble.
The researchers into prospect theory do not make the following point. Rather than admitting to ourselves that the bet is bad, we latch on to speculative narratives. We discard our normal rational cynicism, so turning the bad bet into a good bet in our minds (see Brown 2017). For example, turning to the third industrial revolution narrative above, interest income famine investors might be over-gullible, overlooking serious flaws and downsides in the new technology as reflected in the generally disappointing growth of living standards (on average, over the whole population).
Beyond these two troubling aspects, Shiller is prone in this book to cite certain economic judgments as final and universal that are far from settled. Some readers may feel that Shiller is a John Maynard Keynes enthusiast, exaggerating the power of narratives attributable to that economist. To be fair, however, it is a fact that Keynesian narratives, whether in original or mutated (neo-Keynesian) form have penetrated far into economic (including monetary) policymaking around the globe. Shiller understandably seeks to explain this penetration in line with his principles of narrative economies.
The author does suggest that the contagious success of Keynesian economic narratives depends on any factors other than inherent brilliance. As well as stressing the importance of Keynes’s celebrity status, Shiller mentions the role of the Hicksian IS-LM diagram in propagating Keynesian economics. The resemblance of its two schedules to the well-known supply and demand curves of simple price theory has indeed been crucial. But Shiller does not consider explicitly the attraction of Keynesian doctrine to politicians seeking to win elections by fine tuning the economy or by ignoring red ink in the budget resulting from tax cuts and increased outlays. It is no wonder that such governments and their advisors are keen to propagandize Keynesian narratives.
In general, however, Shiller tends to exaggerate the spread of narratives, underestimating the heterogeneity of opinion in the economy and the marketplace, even when these seem very powerful.
Let’s give some illustrations of the above reservations concerning narrative economics as Shiller develops them in the book.
Shiller quotes the spread of the message in Keynes’s polemic The Economic Consequences of the Peace (1919) as an example of an economic narrative that had tremendous power, which he attributes in part to the role of Keynes as a celebrity (including his membership in the Bloomsbury Circle). For Shiller this narrative was based on substantial truth: “Keynes was right (about the fatal consequences of reparations as demanded in the Treaty). World War Two began amongst lingering anger twenty years later and cost 62 million lives.”
But Shiller fails to mention the huge flaws in the 1919 polemic: for example, Keynes failed to consider the possibility of an economic miracle in Germany that would pull in huge amounts of foreign capital (as occurred from 1924–28, albeit eventually blighted by the fantastic asset inflation fueled by the Federal Reserve). Although the unquantified reparation demands in the Peace Treaty did initially result in a massive bill, presented to Berlin in 1921, the Dawes Plan (1924) scaled these demands down hugely.
Undoubtedly the reparations narrative formed a key part of the National Socialist propaganda campaign in the years 1929–30. (Germany and its creditors were then negotiating a new reparations deal, the Young Plan.) Yet the success of that propaganda, and more generally the rise of Hitler (who became Chancellor in January 1933), reflected fundamentally the calamitous bust of the global bubble with the Weimar Republic at the epicentre. The source of the bubble had been the huge monetary inflation (camouflaged in goods markets by rapid productivity growth and an abundance of commodity supplies) generated by the Federal Reserve between 1921 and 1928.
The spread of the Keynesian narrative about the disaster of reparations in The Economic Consequences of the Peace depended in large part on its appeal to two powerful political groups—the nationalists (including National Socialists) in Germany, who could cite a celebrity English economist to validate their view that reparations were unacceptable, and US isolationists, who scored early success in their opposition to the Versailles Treaty and collective security via the League of Nations.
We should also note that in the marketplace of 1919–21, Keynes’s narrative was far from dominant. There was a huge tide of speculators buying Reichsmarks in the belief they had become so cheap that only recovery could lie ahead (see Brown 2011). Keynes himself lost a fortune (almost going bankrupt) in shorting the Reichsmark at this time, believing his own narrative.
Let’s move backwards in history to the 1890s. Shiller maintains that the depression (and high unemployment) during much of this decade stemmed from the narratives about the bimetallist controversy that were being spread. Bryan’s Cross of Gold speech in 1896 was the epitome of a campaign advocating bimetallism that had already been waged for several years. Implementation would mean a major devaluation of the dollar against gold (and thereby the European gold currencies).
Shiller argues that an emotional bimetallist narrative about the hardships that much enterprise (including farmers) and ordinary working people would face if “Eastern intellectuals” had their way and the dollar stayed on the gold standard seriously aggravated general economic pessimism and thereby the weakness of the economy in these years. But there is an alternative hypothesis that Shiller does not consider.
The lack of confidence in the US remaining on the gold standard was reflected in a drain of gold and cash (the latter somewhat irrational) from the banks, a trigger to the great crash of 1893 (see Rothbard 2002). The drain forced interest rates up, adding to the forces of recession in the economy—analogous, though not identical, to the effect of speculation on the US exiting the gold standard on the length and duration of the Great Depression. Shiller’s discussion of gold narratives in this book includes the unquestioning recitation that the gold standard was a cause of the Great Depression, which is jarring for readers aware of the strong counterarguments.
Similarly jarring is the author’s exclusive focus on narrative as the causal factor in the housing bubble and bust in the US from 2002–07. Shiller argues that the spread of narratives about housing prices always rising, the homeownership revolution, and the profit to be made in “flipping” all generated the bubble. But he makes absolutely no mention of President Bush’s nomination of Ben Bernanke to the Fed Board in 2002 or of his getting Alan Greenspan to sign on to a great monetary inflation ahead of the 2004 elections. Shiller subsumes these facts under a radical departure in US monetary history, “breathing inflation back into the economy.”
And no mention is made of the preceding great monetary inflation of 1995–99, during which the housing bubble had started to ferment. This inflation stemmed from the Greenspan Fed’s response to downward pressure on reported goods and services inflation (due to a productivity surge), by leaning against a rise of interest rates.
Further back, when Shiller recounts how the US economy suddenly rebounded from the Great Recession of 1920–21, he stresses narratives about “a return to normalcy.” But why is there no mention of the first great contracyclical monetary experiment of the Federal Reserve at that time (Rothbard 1972), which under tremendous political pressure made a huge injection of monetary base into the system? The same political forces resulted in the Fed unofficially turning toward price stabilization for the rest of the decade, even during a period of rapid productivity growth, which would fuel one of the greatest asset inflations in US history.
It is fine that Shiller advocates a major research drive into narrative economics. But if this is not to be a flawed endeavor, it must be built on a monetary pillar, and one which is well founded.
Shiller and his disciple researchers should examine one of the biggest narratives, false in the long run but self-fulfilling in the short run, and repeated tirelessly in much of the financial media. According to this narrative, central banks can improve economic outcomes through their rate manipulations and nonconventional tools. This narrative is not totally new. Part of the boom-or-bubble psychology of the 1920s was built on the narrative that the recently created Federal Reserve had the power to stabilize the economy and avoid the financial turbulence of previous eras. Similar narratives may be found in the 1960s, with the wonders of a new Keynesian Fed, and in the 1990s, with the Great Moderation due to the Maestro at the Fed. Nothing less than a ruthless and comprehensive criticism of such major monetary narratives should be expected from Shiller and his disciples in forging ahead with the new subdiscipline of economic narratives.
Abstract: This paper extends Austrian business cycle theory to the command economy and demonstrates that Mises’s socialist commonwealth would not be free from Rothbardian error cycles, which J. Guido Hülsmann has argued must originate in “institutions in which the error of many persons is inherent.” Booms and busts are shown to be unavoidable under socialism because (1) the central planner’s incomplete understanding of the opportunity costs associated with any given rate of growth would result in growth targets that are unsustainably high and (2) the planner would be blind to the resulting imbalances until they became sufficiently severe to become “visible” in the statistical data that form her only picture of the world. In this case, Hülsmann’s “erroneous institution” is central planning, which misidentifies the state’s image of the economy with the totality of economic reality.
JEL Classification: B51, B53, E32, P21, P51 Mark A. DeWeaver (madeweaver@gmail.com) is an adjunct professor at American University’s Kogod School of Business and cofounder of the fund management company Ithaca Advisors, LLC. The author would like to thank the participants at the 2019 Libertarian Scholars Conference and an anonymous referee for their helpful comments and suggestions.
“Economic construction proceeds in wave-like fashion with its ups and downs, and one wave chasing another. This is to say that there are balance, disruption, and balance restored after disruption.”–Mao Zedong (1959)
It is often supposed that business cycles would not occur under central planning. Indeed, in most business cycle models a central planner should be able to improve upon the “anarchy of the market.” Keynes’s ([1936] 1997) animal spirits could be eliminated, the adaptive expectations of Samuelson’s (1939) accelerator/multiplier model could be replaced by a rational program, the planner’s supposed informational advantages would solve the incomplete information problem in the Lucas (1972) rational expectations story, and, in the absence of the “exploitation” of labor by capital, Marx’s ([1863] n.d., chapter XVII, part 6) “crises of accumulation” would not occur.
Although most business cycle theorists have not explicitly advocated central planning, explanations based on the limitations of private actors can easily be misinterpreted as implying that eliminating market forces would be an improvement. Keynes ([1936] 1997, 320) makes this claim explicitly, arguing that “the duty of ordering the current volume of investment cannot safely be left in private hands.” Here the implicit assumption is that the state official will behave more rationally than the businessperson, a view entirely consonant with Keynes’s lifelong advocacy of socialist policies (Fuller 2019). His argument is a good example of what Demsetz (1969) calls the “nirvana approach”—a case for state intervention made by contrasting real-world free market outcomes with what an ideal government could achieve in a “first best” world. Keynes is essentially saying that a system directed by angels would be preferable to one run by fallible human beings.
In the Austrian tradition the planner tends to be seen as demonic rather than angelic. Here too, however, we find claims that central planning would not generate economic fluctuations. In Human Action, for example, Ludwig von Mises ([1949] 1998) argues that the periodic crises experienced in free enterprise economies, which he attributes to incompatibilities among the plans of different economic actors, would not occur under socialism, which would allow for only one plan—that of the dictator. “If the dictator invests more and thus curtails the means available for current consumption,” he writes, “the people must eat less and hold their tongues. No crisis emerges because the subjects have no opportunity to utter their dissatisfaction” (566). Although rational decision-making would be impossible in his socialist commonwealth, there would at least be no booms and busts.
Similarly, for Huerta de Soto (2006) the claim that “an economy of real socialism offers the advantage of eliminating economic crises is tantamount to affirming that the advantage of being dead is immunity to disease.” If cycles are not observed in socialist countries, this is not the mark of a superior system but rather a sign that they are “are continually and permanently in a situation of crisis and recession” (472–73).
Yet the economic history of socialist countries includes boom-bust episodes that in many cases have been even more extreme than those observed elsewhere. Kornai’s (1992) classic study of the Soviet Union and Eastern Europe found that “while some socialist economies grow relatively smoothly, others show wild fluctuations, even larger ones than in many capitalist countries” (187). He noted that the coefficients of variation for annual investment growth in Yugoslavia, Poland, and Hungary were 278 percent, 187 percent, and 171 percent, respectively, all higher than those for the capitalist countries in his sample, which covers the period from 1960 to 1989. (Of these, Ireland had the highest value, at 159 percent.) Similarly, the Chinese economy has experienced dramatic cycles in fixed asset investment going back to the Great Leap Forward in 1958 (Eckstein 1976; Fan and Zhang 2004; Wang 2008; DeWeaver 2012).
Research on Soviet-type economies has generally attributed cyclical fluctuations to inconsistencies in the central plan. Wellisz (1964, 233), for example, describes the plan as being “fitted together like a jig-saw puzzle,” where “an individual piece cannot be trimmed or replaced without spoiling the whole picture.” This meant that “a weakness is tolerated as long as possible in order to avoid rearrangement of all the pieces. Finally, when the situation becomes unbearable, radical steps are taken to remedy it. Thus, the economy proceeds by starts and jolts, with successive drives or campaigns to eliminate this or that mistake.”
Winiecki (1988) shows how this state of affairs resulted from enterprises’ efforts to have their projects included in the five-year plan (FYP) by exaggerating the projected benefits and underestimating the costs. “In consequence,” he finds, “the FYP typically starts with significant built-in distortions in its investment component. These distortions exercise, over time, an increased pressure on aggregate equilibrium…shortages multiply and excess demand begins to grow.” In the majority of cases, the cycle peaked in the second or third year of the plan, at which point the planners “resign themselves to the fact that all planned investment projects will not be completed by the end of the FYP…many projects are ‘mothballed’, with further construction postponed until the next FYP, and some others discontinued altogether” (1988, 20–21).
In practice, it is evident that central planning has never been an antidote for economic fluctuations. It might still be argued, however, that these historical precedents do not rule out in principle the possibility of a stabilizing role for the planner. If administrative arrangements specific to the countries involved account for the volatility of the socialist economies, perhaps the system might somehow be “perfected,” for example by improving the incentives facing enterprise managers and local-level officials. Under ideal conditions, socialism without booms and busts might yet be achievable.
Here my objective is to show that this is not the case. I extend Austrian business cycle theory to the command economy by showing that malinvestment will still occur under central planning whenever any form of economic growth is prioritized. The model, which combines Friedrich Hayek’s (1945) insights on the importance of local knowledge with Scott’s (1998) concept of “legibility,” assumes a planning authority with a limited, though time-varying, statistics-based picture of economic conditions. Cycles then correspond to changes in what can be “read” through statistical data. I find that Mises’s calculation problem implies not only static but also dynamic inefficiency.
The fundamental issue is the planner’s lack of access to local knowledge, which makes comprehensive planning an impossibility regardless of how the plan is formulated. Ideal local-level officials might selflessly follow the leadership’s directives in every particular but will find that these are incomplete. Much will still have to be left to the discretion of the “cadre on the spot,” as Hayek might have put it, who will have to set aside his local-knowledge advantage to focus on plan fulfillment. Investment fluctuations will be unavoidable, because (1) the planner’s incomplete understanding of the opportunity costs associated with any given rate of growth will result in growth targets that are unsustainably high and (2) the planner will be blind to the resulting imbalances until they became sufficiently severe to become “visible” at the aggregate level.
Although the institutional setting is different—administratively set targets take the place of monetary expansions—these dynamics are essentially the same as those described in Austrian business cycle theory. In both cases, faulty signaling of society’s rate of time preference leads to the misallocation of resources into more roundabout production, resulting in distortions that must inevitably be corrected through an investment slowdown. When shortages become sufficiently severe, the central planner will be forced to restore order through administrative measures much as central banks in today’s market economies have to “take away the punch bowl” when faced with rising inflation.
Today, the socialist business cycle is not only of theoretical and historical interest but also of great practical importance. In China the investment cycle continues to be primarily a state-led phenomenon, operating in much the same way as it did in the pre-reform era (DeWeaver 2012). Booms continue to be driven by investment promotion at the local government level while busts result from central government administrative interventions designed to reimpose macroeconomic stability. Although prior to the beginning of the “reform and opening” period in 1978, the Chinese economy’s ups and downs had relatively little relevance to the outside world, today they impact everyone from Swiss watchmakers to Zambian copper miners.
The business cycle in the socialist commonwealth can be considered as an example of what Hülsmann (1998), following Rothbard ([1962] 2004, ch. 11), calls an “error cycle.” The root cause of any business cycle, he argues, is what he refers to as an “illusion”—an error that is independent of time and place and can therefore give rise to recurring erroneous behavior. In this case, the illusion is built into the very idea of central planning. It is the misidentification of the image of the economy that is visible to the planner with the totality of economic reality.
The remainder of this paper traces the origins of this illusion, demonstrates why it gives rise to booms and busts, and describes how Austrian business cycle theory can be extended to the centrally planned economy to account for these aberrations. Part I shows how socialism was built on a denial of the economic significance of local knowledge, which made it possible for theorists to believe in the possibility of an all-seeing planner. Part II presents a model of fluctuations in an ideal socialist commonwealth and demonstrates that these fluctuations can be considered as a subspecies of the Austrian business cycle where state-set output targets play the role of free market interest rates as a signal of society’s rate of time preference. In part III, I review Hülsmann’s argument and argue that his “essentialist” error-cycle approach is particularly well suited to this case. Part IV concludes.
I. THE BIRTH OF AN ILLUSION The founders of the Soviet system believed that industrial modernization would give rise to the conditions necessary for central planning to work by eliminating the relevance of local knowledge. This idea is implicit in Marx’s claim that with advanced factory technology “the motion of the whole system does not proceed from the workman but from the machinery,” implying that “a change of persons can take place at any time without an interruption of the work.” (Marx [1887] 1999, 285). Standardization and automation would leave Hayek’s man on the spot with no particular informational advantages. Anyone could take his place.
Similarly, Engels ([1894] 1975) believed that modern industry had “freed production from restrictions of locality.” “Water power,” he noted, “was local; steam power is free” (351). Where “knowledge of the particular circumstances of time and place” (Hayek, 1945) would obviously be important for siting a water-powered mill, replacing water with steam could potentially make an understanding of locality-specific geographic conditions largely irrelevant. Engels expected that it would become possible for any factory to be located practically anywhere as technological progress swept aside the myriad local differences that had formerly constrained economic development and would allow “industry to be distributed over the whole country…on the basis of one single vast plan” (Engels [1894] 1975, 351).
Lenin (1920) later updated this conception, replacing steam with electric power. Capitalism, he claimed, “depends on small-scale production and there is only one way of undermining it, to place the economy…on a new technical basis, that of modern large-scale production. Only electricity provides this basis.” Hence his famous dictum, “Communism is Soviet power plus the electrification of the whole country.”
The backwardness of peasant Russia, he went on, would be transformed by power stations, which would become “strongholds of enlightenment.” Electricity would not only light up the night but would also create a manufacturing base free from the idiosyncrasies of traditional economic arrangements. The central planner would not be groping in the dark but able to see clearly. Lenin was aiming at something much more than the electrification of the whole country. He hoped to leverage the rationalizing potential of technology to achieve what Scott (1998) refers to as the “thoroughly legible society,” which “eliminates local monopolies of information and creates a kind of national transparency” (78).
There would then be no need for the “new dispositions made every day in the light of circumstances not known the day before” that Hayek (1945, 524) argued were essential to the “continuous flow of goods and services.” Instead, as Nikolai Bukharin and Evgenii Preobrazhensky claimed in their 1920 book The ABC of Communism, the state will “know in advance how much labor to assign to the various branches of industry, which products are required and how much of each it is necessary to produce; how and where machines must be provided” ([1920, trans. 1922] 2001, chap. 3). Chaotic interactions among privately owned firms would give way to a smoothly functioning state-directed mechanism.
In China, where Bukharin and Preobrazhensky’s readers included Mao Zedong, Deng Xiaoping (Wu and Ma 2016, 23), Beijing mayor and Politburo member Peng Zhen, and People’s Liberation Army founder Zhu De (Snow 1968, 271, 335), this notion was taken up uncritically by the Chinese Communist Party. It is, for example, the unstated assumption behind the “chessboard strategy” described in the famous 1959 People’s Daily editorial “The Whole Country as a Chess Game” [Quan guo yi pan qi]. Written in response to the chaos following the launch of the Great Leap Forward in the previous year, it called for a return to disciplined central planning, likening the national economy to a chessboard, on which the movements of each piece must conform to an overall strategy based on the rules of the game. Implicit in this analogy is the idea that it would be possible for economic life to be just as transparent to the planner as a board game is to the players.
In practice, of course, technology has not created anything like the level of national transparency envisaged by any of these authors. The operations of a large-scale factory can no more be reduced to a straightforward set of rules than the techniques of the traditional artisan. Modern forms of communication have not eliminated “knowledge silos” in complex organizations. Computer algorithms seem unlikely ever to penetrate fully the opacity of asset markets.
Innovations may render older categories of economically significant local knowledge obsolete but may be equally likely to create new ones. Consider the case of the defense aerospace industry. There, Gilli and Gilli (2018) note that “the number of components in military platforms has risen dramatically: in the 1930s, a combat aircraft consisted of hundreds of components, a figure that surged into the tens of thousands in the 1950s and to 300,000 in the 2010s.” As a result, “the number of potential incompatibilities and vulnerabilities” has increased “geometrically” (150) and “the knowledge related to a given weapon system has become increasingly less codifiable—it has become tacit” (163). Unlike the knowledge required to produce a World War I era biplane, which could to a large extent be derived from a blueprint, the essential knowledge resources behind a platform such as Lockheed-Martin’s Joint Strike Fighter are primarily local, residing in the collective memory of an organization and difficult if not impossible to express in any explicit form. From this example it is easy to see that advances in technology can have exactly the opposite effect from that expected by the early socialists, making the workings of the industrial system ever more opaque.
There can thus be no central planning that does not rely on “state simplifications” that are “always some distance from the full reality these abstractions are meant to capture,” as Scott (1998, 77) puts it. These, he argues, differ from the full reality because they (1) “cover only those aspects of social life that are of official interest,” (2) “are nearly always written,” implying that nondeclarative knowledge is necessarily left out, and are (3) “typically static,” (4) “aggregate,” and (5) “standardized.” In the real world, where the relevance of different types of information is constantly changing and the particular circumstances of time and place continue to be economically relevant, there will unavoidably be significant blind spots in the planner’s “synoptic” view.
The problem, as Hayek (1988, 85) pointed out, is that “what cannot be known cannot be planned.” But even in the absence of an adequate basis for decision-making, plans will still be made. Decisions will be taken based on whatever the central planners can “see” at any particular time as the bureaucracy collectively succumbs to the illusion that this is a complete picture. Policy goals will necessarily be limited to targets for “synoptically observable abstractions” while the unobservable details of their implementation are left to officials at the local level. The extent to which such a system gives rise to booms and busts will thus depend critically on the activities of these lower-level cadres.
II. BOOMS AND BUSTS UNDER CENTRAL PLANNING The local cadre’s responsibility for realizing targets for aggregate variables will be economically destabilizing, because he will be incentivized to generate outcomes that the central government can observe but not to take the associated unobservable economic costs into consideration. As a result, resources will be diverted into planned policy priorities at the expense of activities that are not emphasized, or even contemplated, by the plan. There will be chronic contradictions between the needs of the actual economy and the plans of the economic decision-makers.
When increasing economic output is the primary objective, as has generally been the case historically, this may in principle be achieved through either extensive or intensive growth. But only the former (increasing output by using more inputs) falls within the competence of the planner. Intensive growth, which relies on increased productivity, is intrinsically unplannable. It is straightforward to set material targets for specific items (tons of steel, kilometers of railway lines), as was commonly done in the Soviet Union (Davies 1974), or goals for aggregate measures such as provincial or municipal GDP growth, which have been typical in post-reform China (Zhou 2004). But similar “state simplifications” (e.g., number of patents issued) do a poor job of incentivizing genuine innovation.
Attempts to transform the “mode of economic growth” in the Soviet Union and, more recently, in China have been notably unsuccessful. In the 1980s, the Soviets adopted the policy of uskorenie (acceleration), “subordinating everything to the aim of making the economy more intensive and achieving higher production outputs with smaller inputs and less resources” (Tikhonov 1981, 24), which was to be facilitated through the “universal introduction of fundamentally new machinery and materials and the large-scale use of highly efficient energy- and material-saving technology” (Tikhonov 1981, 29–30). This produced few breakthroughs. The difficulties can be seen from the experience of the machine-building industry, a top priority sector, where of the three thousand new products introduced in 1986 to satisfy innovation targets, 40 percent were found to have involved “no substantial shifts” in technology (Matosich and Matosich 1988).
Similarly, every Chinese five-year plan since 1981 has emphasized the importance of greater economic efficiency for the country’s future development (DeWeaver 2012, chap. 9). Yet levels of excess capacity in industrial sectors such as steel, cement, float glass, and aluminum—to name but a few—have skyrocketed while China’s incremental capital-output ratio has been on a steady uptrend since 2007. And although the jury is still out on Beijing’s “National Medium- and Long-Term Plan for the Development of Science and Technology (2006–2020),” its goals illustrate the difficulty of transitioning to intensive growth using command economy methods: R&D expenditure is supposed to increase to 2.5 percent of GDP, reliance on foreign technology must fall to 30 percent, China must reach fifth place globally in number of patent filings, and so on (McGregor 2010).
Given the obvious problems with raising productivity by fiat, the planner will generally find that extensive growth is the only viable option. As she cannot be aware of all of the opportunity costs associated with any given growth rate, she will necessarily set growth-rate objectives (whether for the entire economy or for specific sectors) that are unsustainably high. The cadre on the spot will respond by investing in infrastructure and the manufacturing base. Hitting material targets will require additional fixed assets once the existing capital stock is fully employed. Investment drives will also be the surest route to an aggregate output benchmark, both because fixed asset accumulation is itself a part of aggregate output in the period in which it occurs and because it makes it possible to increase output in subsequent periods. Although the cadre might conceivably attempt to introduce local-level productivity enhancements, his first choice will be to mobilize factors of production that he perceives as having an opportunity cost of zero because they are currently employed in activities that lie outside the planner’s field of vision.
Murray Rothbard ([1962, 1970] 2004, 337) notes that intertemporal transactions may take the form of either credit extension or the “purchase of producer goods and services.” The latter, he points out, are effectively “future goods” because they will be converted into final products in future periods. In the socialist commonwealth, although money and credit may not exist at all, it will be no less true that the employment of producer goods and services constitutes a substitution of future for present output. And in the absence of changes in productivity or in the availability of land and labor, any growth rate set by the planner will imply a specific requirement for additional capital, which will in turn require some particular increase in investment at the expense of consumption.
Thus, under central planning, state-set targets for output increases based on an extensive growth strategy play an analogous role to the interest rate in a free market system. Both are signals of the rate at which society is willing to sacrifice present for future consumption, that is, of its rate of time preference. Prioritizing economic growth under central planning will therefore give rise to the same outcome as artificially lowering interest rates in a credit-based economy: resources will be shifted into more roundabout production processes. Growth targets have essentially the same effect on the cadre on the spot as do interest rate cuts on Hayek’s man on the spot. Both skew the investment decision-maker’s incentives in favor of subsequent periods, resulting in a mismatch between the aggregate requirements of investment projects and the means available to carry them out.
Alfred Zauberman (1964, 25) notes that historically central planners have generally behaved as “managers of a joint stock company whose shareholders are future generations.” In other words, we may think of them as assigning a discount rate of zero to outcomes occurring at some indefinite date in the future. That Austrian business cycle theory, with its emphasis on faulty signals of society’s true rate of time preference, should be applicable to “actually existing socialism” is thus unsurprising.
In both the socialist and free market cases the outcome will be the same: an initial boom that eventually leads to a crisis as the resulting imbalances become unsustainable. Although in a free market such a crisis can be resolved more or less spontaneously, in the absence of price signals a resolution will not be possible until the essential features of the situation at last come clearly into focus for the planner.
Even under central planning a course correction will eventually be possible, because the planner’s picture of the world, although always incomplete, will not be unvarying. The presence of widespread problems in parts of the economy that the planner cannot see will eventually manifest itself through the aggregated information that she can see, revealing disruptions such as raw materials shortages, crop failures, power outages, and transportation bottlenecks. At this point, the threat to longer-term economic growth will force the planner’s attention to shift from growth targets to the alleviation of shortfalls. Investment plans will have to be cancelled or put on hold as resources are redirected toward previously neglected activities. This will lead to a crisis analogous to those observed in the free market case, though centrally directed rather than the result of a multitude of individual decisions. Given that the planner is the only truly autonomous decision maker, there will be only a single determination that the plan is incompatible with the available resources rather than the mass panic that occurs when “all or nearly all businessmen find that their investments and estimates have been in error” (Rothbard [1962] 2004, ch. 11). Rather than running for the exits on their own, the local cadres will have to be instructed to do so. “The brake” as Kornai tells us, “is applied by central control,” after which a period of austerity will be necessary until such time as the leadership is “reassured that tension has fallen, or even a measure of slack, an apparent underuse of resources, has appeared” (Kornai 1992, 190, 192).
These socialist slowdowns will be no less prone to inefficiencies than the booms that precede them. Lacking the ability to determine whether or not specific activities make economic sense, the planner will have to use arbitrary criteria such as project size or industry type in determining which investments to halt. There will be no way to avoid throwing out the baby with the bathwater.
Just as in a free market economy, the fact that decision-makers have experienced one cycle does not mean that they will be able to avoid another. The details may be different the next time—novel investment rationales may be imagined, innovative technologies may be employed, new sectors may be involved. But as long as economic growth remains the priority, the fact that planning must be conducted in the absence of local knowledge guarantees that recurring rounds of malinvestment will be unavoidable.
Investment booms are not merely a possibility under central planning, but a logical inevitability. This conclusion follows from the following three premises:
The planner’s primary objective is economic growth, whether this be growth in an aggregate measure such as GDP or in output statistics for particular priority sectors.Local knowledge will be economically significant regardless of how the economy is organized.Plan fulfillment is the sole objective of the cadre on the spot.Premise (3) means that the cadre on the spot will take advantage of the lacunae in the plan resulting from premise (2) to meet the planner’s targets. And because (1) implies that future output increases will be targeted, it will be optimal for him to overinvest in roundabout production processes regardless of the resulting malinvestment at the macroeconomic level.
Busts are a logical inevitability as well if we add the following two additional premises:
The macroeconomic effects of malinvestment must eventually become general knowledge.These effects will pose a threat to longer-term economic growth if left uncorrected. These imply that the planner must at some point become aware of the intertemporal distortions resulting from the extensive growth strategy and introduce new policies to resolve them, thereby terminating the boom. Although the subjects may have “no opportunity to utter their dissatisfaction” and initially have to “eat less and bite their tongues,” as Mises argued, this state of affairs will obviously have to end at some point before the entire population has starved to death.
III. SOCIALIST ERROR CYCLES J. Guido Hülsmann (1998) presents an alternative approach to modeling business cycles based on what he refers to as an “essentialist” account of the errors in investment decision-making that drive them. He believes that conventional “consequentialist” stories are unsatisfactory because “as long as human beings choose, that is, as long as they are beings with free will, the correctness of choice must in principle be unrelated to preceding events and choices” (8). The problem with traditional Austrian business cycle theory (ABCT) specifically, he argues, is that it is not generally valid to claim that increases in the money supply cause entrepreneurs to invest in projects that will later turn out to be unprofitable. There is no reason in principle why they could not foresee that these investments would fail and choose not to make them.
During a boom a significant number of people make the same mistake at the same time. Consequentialism explains this clustering of errors as the result of an event (e.g., a money supply increase) that leads decision-makers to err in some particular way. Hülsmann proposes that we instead take error as “the ultimate given.” The question then becomes not “how does error come about?” but rather how can we explain the “repetitive occurrence of more or less synchronous errors of many persons.” This requires identifying “more or less permanent patterns of action (institutions) in which the error of many persons is inherent.” Such an institution must be built upon “a kind of error that is independent of time and place,” which Hülsmann calls an “illusion” (1998, 8–9).
For Hülsmann, this institution is government, which he sees as founded on the illusion that society cannot function in the absence of the institutionalized violence of the state. The task for the theorist is then to “identify particular instances of government intervention and spell out precisely where the illusion is manifest.” There will be “various specific error cycle theories (the economic aspect of which would be specific business cycle theories)” (1998, 14).
My argument in part II is consequentialist—error is caused by the planner’s failure to access local knowledge, which results in the provision of malincentives to her subordinates. Note that this model differs from conventional ABCT in that the faulty decision-making is centralized. While in both explanations the malinvestments occur at the local level, these are only truly errors for the man on the spot. The cadre on the spot is a representative of the state, not an autonomous individual. His activity consists solely in carrying out instructions, using the resources at his disposal in a manner that is optimal for his plan-fulfillment objective. Ultimately it is the planner who errs by mistaking statistics for reality, thereby choosing means that must ultimately prove suboptimal for achieving her long-term goal of maintaining economic growth. This difference is a natural consequence of the cadre’s relative lack of decision-making autonomy. Unlike his free market counterpart, he is not really at liberty to decide whether or not to invest. This decision is imposed on him by the logic of a system set in motion by a single authority acting in the name of the “people” as a collectivity rather than by the aggregation of decisions made by the individual citizens themselves via the market process.
On a more fundamental level, reformulating the story in essentialist terms reveals that the socialist cycle may be thought of as a particular instance of Hülsmann’s general theory. If government is indeed an “illusory institution,” under socialism, where economic life is entirely dominated by the state, recurring erroneous behavior will be unavoidable, though this behavior will be concentrated in the person of the planner, who is uniquely empowered to set the objectives for society as a whole. (Alternatively, we may think of Hülsmann’s “synchronous errors of many persons” as being made by ideal cadres whose individuality has been entirely merged into a single collective “popular will” and therefore err collectively rather than individually.) And we may identify central planning as being “precisely where the illusion is manifest.” Indeed, we can be even more certain that “it is not money but government intervention that accounts for the business cycle,” as Hülsmann concludes, in a commonwealth where interest rates are not relevant to investment and money, at least in a theory, might not even exist at all.
Mihai Macovei (2015, 433) finds that “the essentialist approach is useful, but lacks convincing arguments to become a general theory of business cycles”. He challenges Hülsmann’s claim to generality on two counts. First, a story premised on the idea that government is essentially a form of institutionalized aggression can easily be rejected by anyone who does not happen to share this view. Second, “except for the ABCT, Hülsmann only mentions two other possible examples, such as the ‘military-imperialistic’ and the ‘social security’ cycle. He does not develop them further in order to explain their workings, which is a clear shortcoming in terms of expounding a theory that claims to be general and all-encompassing” (2015, 427). Furthermore, Macovei argues that even the “argumentation” underlying the essentialist reconstruction of the ABCT is “not irrefutable” (2015, 433).
Our consideration of the socialist business cycle, although not relevant to Macovei’s specific objections to this argumentation, suggests possible counterarguments to his two more general points. It suggests, first of all, that the key characteristic of the state for the purposes of business cycle theory may be blindness rather than violence. This position is defensible given the obvious economic importance of local knowledge and the fact that planning is no less a part of any government’s activity than coercion. In addition, one can point to the socialist cycle as an additional special case, thereby strengthening the assertion that the theory is “general and all-encompassing.”
We may think of central planning as one specific instance in which the illusion of government, as Hülsmann characterizes it, is manifested, thereby arriving at a specific version of his general theory appropriate to the socialist commonwealth. But we may also restate this general theory by considering faith in governments’ ability to plan, rather than belief in the necessity of state property rights violations, to be the illusion underlying government itself—not an unreasonable view given that the former must presumably precede the latter. The business cycle then becomes less a consequence of the expropriation of private property than of the state’s inability to use what it has taken in an efficient manner. This restatement has the advantage of making the essentialist position easier to defend while leaving it basically intact.
IV. CONCLUSION In Economic Calculation in the Socialist Commonwealth, Mises argues that without access to the local knowledge embedded in the price system, the socialist economic order will end up “floundering in the ocean of possible and conceivable economic combinations without the compass of economic calculation” (23). In the absence of any rational basis for decision-making, “the wheels will turn, but will run to no effect” (19).
Here, I have made a case for going beyond Mises’s essentially static framework to explore his argument’s dynamic implications. The planner may never see a complete picture of the economy, but what she does see can nevertheless be expected to vary over time. As a result, her mistakes will be serially correlated, leading to a pattern of alternating overinvestment and austerity not unlike a series of private sector manias and panics. Although the wheels will “run to no effect,” they will run faster during some periods than others.
The incentive issues and political factors characteristic of real-world socialism complicate the story without changing its essential features. The main difference between our idealized commonwealth and existing socialist countries is that real cadres will find ways to influence the contents of the plan and strive to overachieve its goals (Winiecki 1988, Kornai 1992, Zhou 2004). Their priority is typically not plan fulfillment per se but advancing their own careers. But the basic problem—the diversion of resources from activities outside the planner’s field of vision—will be the same, though exacerbated by cadres’ attempts to game the system. The possibility of eliminating booms and busts through administrative reforms can also be ruled out. Central planning is inherently destabilizing.
It is straightforward to generalize Austrian business cycle theory to include both planned and market economies. In either setting, the essential features of the cycle are: (1) an expansionary impulse resulting in (2) a distorted signal of society’s rate of time preference, followed by (3) malinvestment, (4) excess demand, and finally (5) contraction. Under socialism, we simply have the planner in the role of the banker, with the planner’s economic growth policy replacing money supply increases as the expansionary impulse and unrealistically high output targets taking the place of below equilibrium interest rates as the distorter of the time preference signal. In either case, the result is malinvestment, while the excess demand may be manifested either directly, as physical shortages, or indirectly, as inflation. The final contraction will provide the same necessary readjustment whether it results from administratively imposed austerity or interest rate increases.
Far from being an impossibility, as many have imagined, the socialist business cycle may in fact be the state-driven business cycle par excellence. Without markets and private property, policy does not have to be transmitted indirectly to the private sector through a monetary or fiscal “transmission mechanism” nor are there any truly independent decision-makers. The state’s economic management will have a direct and immediate impact and cannot fail to produce booms and busts under the five assumptions enumerated at the end of section II.
The socialist business cycle is also arguably the Hülsmannian error cycle par excellence. Where there are no private sector “animal spirits,” the source of the “recurring erroneous behavior” is unambiguous. It can only be the state’s blindness to the “particular circumstances of time and place,” whether considered as a specific manifestation of the illusion of government or as this illusion’s ultimate source.
Dr. Joe Salerno joins the show for a dynamic look at Human Action Part Four, arguably the meatiest part of the book.
Chapters 18, 19, and 20 are where Mises presents the idea of pure time preference, his expanded theory of interest, and the parameters of business cycle theory and malinvestment. Salerno and Jeff Deist consider how time relates to capital; gratitude for society's accumulated wealth; convertibility of capital thanks to stock markets; why holding cash can be productive; originary interest as a ratio, the fallacious classical and Marxist notions of interest, and the boom/bust cycle created by politicians, voters, and bankers who see that inflation "works" for awhile. This is a great discussion of Mises at his best!
Use the code HAPOD for a discount on Human Action from our bookstore: Mises.org/BuyHA.
Additional Resources Human Action: Mises.org/HumanAction
Bob Murphy's Study Guide to Human Action: Mises.org/Study
Abstract: This paper offers a synthetic and comparative assessment of the most basic Austrian macroeconomic models, i.e. the models that analyze the static forces determining the equilibrium interest rate and structure of production (monetary disequilibria and business cycles are not part of this investigation). The three models presented here are those of Böhm-Bawerk ([1889] 1959), Hayek (1936, 1941), and Garrison (2001). This review shows that these models are largely inconsistent with each other, but also that at a more general level they share several important characteristics. Finally, a tentative explanation is offered as to why there is no cumulative tradition in the Austrian School in this kind of basic macroeconomic theorizing.
JEL Classification: B13, B25, B53, E14 Key Words: hayekian trianage austrian economics business cycle macroeconomics Renaud Fillieule (renaud.fillieule@univ-lille.fr) is Professor of Sociology at the University of Lille, France, and member of the CLERSÉ research unit (UMR CNRS 8019).
A preliminary version of this paper was presented at the Austrian Economics Research Seminar in Paris, France, May 9, 2017. The author wishes to thank Prof. Hülsmann for this invitation and the attendees for their remarks and suggestions.
INTRODUCTION The Austrian School is best known for its subjectivist approach and for its theories of the market process and the business cycle. This paper focuses upon a less familiar but nevertheless significant topic. Prominent economists of this school have developed, over the century and a half of its existence, a series of basic macroeconomic models. These models are “basic” in the sense that they investigate the most fundamental forces operating in an economic system, leaving aside the complications due to monetary disturbances and to uncertainty. No systematic comparison between them has been provided yet, and this paper seeks to fill this gap. This kind of basic and integrated model analyzes the convergence process of a very simplified economic system towards a macroeconomic equilibrium, and investigates the macro-effects of typical changes such as technical progress, a lower or higher time preference (leading respectively to a larger or smaller saving-investment), or an increase in the number of workers. Monetary disturbances and short-term fluctuations are therefore off topic here. Three models fit these criteria in the published Austrian literature. They were respectively elaborated by (i) Böhm-Bawerk ([1889] 1959), (ii) Hayek (1936, 1941), and (iii) Garrison (2001).Hülsmann (2010) has developed a macroeconomic model that integrates Rothbard’s model of determination of the pure interest rate and the Hayekian structure of production, but it is still a working paper and can therefore not yet be considered as an “official” contender. Fillieule (2005) has expounded a graphical model illustrating the interrelations between various aspects of the economic system, but it lacks a very important element, namely a theory of interest. The first purpose of this paper is to provide a history of the way basic macroeconomic theorizing has been conceived in the Austrian School. The three models will be expounded in turn, with a review covering in each case the convergence process, the final equilibrium characteristics, and the response to typical exogenous changes (Section One). The second purpose is to analyze the relationships between these models and to expose their theoretical inconsistencies (Section Two). The third purpose is to show that, beyond their differences and contradictions, these models have in common a number of significant general features (Section Three). The fourth and last purpose is to seek to explain why—in contrast with the standard neoclassical paradigm since the classic contribution by Solow (1956) and Swan (1956)—no single basic reference model dominates within the Austrian School (Section Four).
- THE AUSTRIAN MODELS: A CHRONOLOGICAL PRESENTATION
This presentation of the three basic macroeconomic models aims at elucidating, as briefly as possible, their framework and internal logic. Many secondary features will be left out, so that the length of the paper remains within reasonable limits. In each case the graphical visualization of the model will be used instead of the mathematical formalization, but the latter also exists.Wicksell ([1893] 1970) developed both the mathematical and the graphical versions of Böhm-Bawerk’s model, Molavi Vasséi (2015) developed the first mathematical formalization of Hayek’s model, and Cachanosky and Padilla (2016) the first mathematical formalization of Garrison’s model.
1.1 Böhm-Bawerk’s Model
Böhm-Bawerk ([1889] 1959) expounds his model in a chapter titled “The Rate of Interest.” However, his theory is not just a theory of interest and turns out to be a genuine macroeconomic model, in which not only the equilibrium interest rate but also the equilibrium wage and period of production are determined. Böhm-Bawerk was a true pioneer in modern macroeconomic analysis, but his exposé was a bit simplistic in that it was based upon a single numerical example. Wicksell ([1893] 1970) quickly replaced this elementary formulation by a general mathematical presentation using differential equations, and also by a convenient graphical display. Much later, Dorfman (1959) improved upon the Wicksellian graphical version of the model.See Fillieule (2015) for a recent and comprehensive graphical account of the model. It must nonetheless be noted that this model has not evolved between its original exposition by Böhm-Bawerk and its subsequent representations. It is exactly the same model, and only its form has been refined over time.
The model rests upon two exogenous data, the quantity of capital K and the number of workers N, and upon an exogenous production function f that relates the total period of production T of the economic system to the quantity qc of consumption goods produced per worker and per year. Figure 1 shows this production function qc = f(T) as a concave curve on the top diagram.Lower cases are used for individual variables, and upper cases for aggregate variables.,Two differences between the production functions respectively used in Böhm-Bawerk’s model and in the well-known Solow-Swan model can be briefly highlighted. First, the Böhm-Bawerkian macroeconomic function of production determines the annual quantity Qc of consumption goods produced, not the total quantity of consumption and capital goods. Second, the argument of this Böhm-Bawerkian function is the period of production T of the economic system, not the quantity of capital K (for a given quantity of labor N). The function f is increasing, which expresses a central tenet of Böhm-Bawerk’s theory of capital, namely that “roundaboutness” is productive: a “well-chosen” more roundabout method of production produces more consumption goods per period, everything else equal (Böhm-Bawerk [1889] 1959, 82–84). In other words, if T increases, then the annual product per worker qc increases. This increase occurs with diminishing returns that Böhm-Bawerk justifies as an “observation... based on experience” (p. 83).These diminishing returns should rather be explained by the fact that there is a fixed factor, namely labor.
Figure 1. Böhm-Bawerk’s model (adapted from Wicksell 1893, p. 122, and Fillieule 2015, p. 309)
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In final equilibrium, two conditions must be fulfilled. The first one is that the whole capital K is invested, no part remaining idle. The second condition is that the capitalists maximize the interest rate (by choosing the appropriate length T for the production process). This optimization condition—maximum interest rate—is visualized on the diagram as the tangency between the production function f and the straight line going through the point (0, w). If the line going through (0, w) rotates clockwise, then the ratio 2/i increases (which implies that the interest rate i falls); if it rotates counterclockwise, then no intersection point appears with the production function f and no corresponding economic system exists. The tangency point therefore represents the highest possible level for the interest rate (equivalently, the lowest possible level for 2/i). The graphical relationship illustrated in Figure 1 between the endogenous variables (i, w, T) is the visual translation of the fundamental equation of the model:
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This equation expresses the distribution of the quantity qc of the annual final product (per worker) between the worker (wage w) and the capitalists (interest ik). The quantity of capital k = (wT/2) invested per worker is viewed by Böhm-Bawerk as the subsistence fund required to carry out the process. If all the production processes started at the same date and simultaneously ended T periods later, then the capital—i.e. subsistence fund—required would be k = (wT) (each worker would “subsist” on wage w during T periods). But production is not organized this way. Rather, it is “synchronized” in the sense that, if the length of the production process is T, then there are T processes occurring simultaneously and at different levels of completion.If a process lasts for three periods, for instance, then a “synchronized” system comprises three simultaneous processes: at the beginning of each period, one process just begins (and will be completed three periods later), another process is half-way (and will be completed two periods later), and the third process nears completion (and will be over at the end of the current period). Thanks to this synchronization, the final product is delivered in each period, instead of waiting for the many periods required to complete a single process. The calculation shows that, with a synchronized production, the subsistence fund required falls from k = (wT) to approximately k = (wT/2). The fund is lower because thanks to the synchronization, a part of the subsistence required to sustain a worker is produced by the processes that reach completion while the process in which this worker participates is still under way. The fundamental equation can be written so that the intercept theorem (Thales’ theorem) applies: this theorem is then used to show that the values (2/i), w, T, and qc(T) are necessarily related in the way illustrated in the diagram in Figure 1 (Wicksell 1893).
The convergence process towards equilibrium is carried out through the actions of the capitalists. The latter aim at maximizing the interest rate while competing to invest their funds. Their actions lead the economic system towards an equilibrium characterized by the values (i, w, T) of the three endogenous variables, namely the interest rate, the real annual wage, and the period of production. The convergence process takes place as follows. Initially, an arbitrary wage prevails. Given this initial wage w0 (w0 < w), the capitalists maximize the interest rate i (in the symmetrical version, the interest rate is given and workers maximize their wage). The maximization of the interest rate is carried out by choosing between the different possible lengths for the structure of production. If the optimal period of production is T0, then the quantity of invested capital is k0 = wT0/2 (per worker) and K0 = NwT0/2 (total). Now, suppose that K0 happens to be below the total available quantity of capital K (exogenous data). The capitalists have some capital left to invest, and they want to invest it to increase their income. So they compete to hire more workers, the demand for labor increases, and the wage therefore rises from w0 to w1. At this higher wage w1, the capitalists once again maximize the interest rate, capital invested once more falls short of the total quantity available, the wage increases again, and so on and so forth. This process keeps on until the wage reaches the equilibrium level w: at this wage, the maximization of the interest rate determines a period of production T such that NwT/2 is just equal to the total quantity of capital K (and this configuration is bound to happen because T necessarily goes up when w does, so NwT/2 increases until it is equal to K). At this point, the whole available capital is invested, and the final equilibrium has been reached.
The two lower diagrams of Figure 1 show how the typical changes are visualized. Technical progress is represented as a counterclockwise rotation of the production function. An increase in the supply of labor N is represented as a downward and leftward shift of the (wT) hyperbola. An increase in the quantity of capital K is represented as a shift of this hyperbola in the other direction. It is then possible to analyze the effects of these typical changes on the equilibrium position and, from there, on the distribution of the final product between capitalists and workers.Böhm-Bawerk (1959 [1889]) thoroughly analyzes the effects of the typical changes on the level of the interest rate, but only cursorily notes the effects on the level of wages (for instance on p. 378). This investigation concludes that technical progress is advantageous both to capitalists and to workers, an increase in the quantity of capital favors workers but not necessarily capitalists, and a rise in the number of workers benefits capitalists but harms workers.Böhm-Bawerk does not take into account here the increasing returns due to the intensification of the division of labor that follows a multiplication of workers. He never mentions these increasing returns in the chapter. He only refers, in the penultimate footnote (1959 [1889], 461, footnote 52), to the diminishing returns on labor brought about by an increasing population. In order for the results to be appropriately interpreted, it should be noted that an individual can be both a worker and a capitalist, even though Böhm-Bawerk seems to implicitly suppose that workers and capitalists are two separate groups of people. Böhm-Bawerk’s model is summarized in Table 1.
Table 1. A summary of Böhm-Bawerk’s model
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1.2 Hayek’s Model
In the early 1930’s, Hayek developed the most famous macroeconomic construct of the Austrian School, namely the representation of the structure of production as a triangle displaying the annual nominal consumption and the smaller and smaller annual investment expended into the higher and higher stages (Hayek [1931] 1935). This illustration was inspired by Jevons (1871), but the latter applied it to a single economic process while Hayek used it as a macroeconomic tool to represent the whole economic system. This Hayekian triangle was quite influential and quickly found its way even among authors not members of the Austrian School, such as Abrams (1934, 25–28) and Durbin (1935, 34) who was then a leading economic expert for the British Labour Party.The author wishes to thank an anonymous referee for these references. It may come as a surprise that this subsection will not at all be devoted to this macroeconomic construct. The first reason is that Hayek did not associate his triangle with a model explaining the determination of the interest rate. This combination was achieved much later by Garrison (1978, 2001) and will be presented in the next subsection. The second reason is that Hayek’s theory of the interest rate (which will be our subject matter here) is incompatible with his triangle, because this theory requires that capital accumulation takes place laterally, while with the triangle capital accumulation takes place longitudinally (see Subsection 2.1).
For these reasons, Hayek’s triangle is left aside for now, and the focus is on his model of the interest rate (Hayek 1936, 1941). Hayek’s model is inspired, not by the theoretical insights elaborated by the Austrian economists since Böhm-Bawerk’s contribution, but rather by the theory of interest developed by the American neoclassical economist Irving Fisher (1930). The main purpose of Hayek with his model is to investigate the question of the determining principle of interest: time preference or productivity? He concludes that productivity is the key factor, but we are not primarily concerned here about this issue. Our focus is on the macroeconomic core of the model, i.e. the convergence towards a macroeconomic equilibrium, the characteristics of this equilibrium, and the study of the effects of typical changes upon the distribution between workers and capitalists.
Figure 2. Hayek’s model (adapted from Hayek 1941, 233). The concave curves are the productivity curves and the dotted curves are the intertemporal indifference curves.
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Hayek (1941) presents his model in a figure inspired by Fisher’s classic intertemporal graph (see Figure 2). The difference with Fisher’s graph is that the vertical axis here measures the final output, not just in the next period, but in each and every future period: at the starting point Q0, for instance, the economic system produces the quantity Q0 of consumption goods in the current period (as shown on the horizontal axis: current output) and also Q0 in each future period (as shown on the vertical axis). The concave curve going through Q0 is the productivity curve, showing the additional output that can be obtained in each future period against the corresponding additional amount of present saving. The convex dotted lines are the intertemporal indifference curves. When the economic system is at the starting point Q0, the actors maximize their intertemporal satisfaction—reach the highest possible indifference curve—by saving ΔS0 and getting ΔQ0 additional final product in each future period. In the next period, the system is at the point Q1, and once again the actors maximize their intertemporal satisfaction, this time through saving ΔS1 and getting ΔQ1 additional final product in each future period. Figure 2 only shows the first step of the convergence process (from Q0 to Q1), but this process goes on period after period, until the system finally reaches the equilibrium point Q. At the point Q, the productivity curve and indifference curve are tangent to each other on the 45-degree line, so that the actors cannot improve their intertemporal satisfaction (i.e. cannot get to a higher indifference curve), either through saving or through dissaving. The economic system has therefore reached a state of final equilibrium: marginal productivity and marginal time preference are equal, and their identical value is the equilibrium interest rate. In other words, the equilibrium interest rate is equal to the common slope of the productivity curve and the indifference curve on the 45-degree line.
Hayek first analyzes the case of a linear productivity curve (1941, 222), and then the more general case of a concave productivity curve (1941, 233). Only the latter, exhibiting the diminishing returns on capital accumulation, is represented here.At this point, we skip the quite important but a bit technical discussion by Hayek of the shape of this productivity curve. When the productivity curve is linear, the equilibrium interest rate is necessarily equal to the (constant) marginal productivity, and therefore does not depend on time preferences. Hayek argues that the productivity curve is linear or almost linear, and concludes that the level of the equilibrium interest rate is determined by productivity, not by time preferences. The bottom diagrams of Figure 2 display the typical changes. The bottom-left diagram illustrates both a technical progress and an increase in the supply of workers, through an upward shift and a rotation clockwise of the productivity curve. The bottom-right one illustrates a lowering of the preference for the present, through a rotation counter-clockwise of the pattern of indifference curves. The effects of these changes upon the distribution of the final output between capitalists and workers, depend on the hypothesis made about the pattern of intertemporal indifference curves. There are two main possibilities: as the economic system becomes more productive and wealthier (climbing the 45-degree line), people can become more present-oriented, or they can become less present-oriented. Correspondingly, the marginal rate of time preference can respectively increase or decrease as wealth grows. Graphically, these two cases are illustrated by the indifference curves becoming respectively steeper or flatter on the 45-degree line (see Figure 3). Under the assumption of a concave productivity curve, the two configurations are compatible with the existence of an equilibrium.In Hayek’s first model, i.e. with a linear productivity curve, then the existence of an equilibrium necessitates an increase of time preference with wealth (Molavi Vasséi 2015). However, the pattern with an increasing time preference is quite unlikely, since it implies that as people become wealthier, they are more and more eager to consume their marginal net income rather than saving and investing it. It is more plausible that, when people become wealthier, they also become more, not less, prone to save an extra unit of present good in order to get additional units in the future (see the discussion in Block, Barnett and Salerno 2006). This pattern—a decrease of time preference with wealth—is illustrated in the right diagram of Figure 3, and the consequences of the typical changes in the case when this pattern prevails are summarized in Table 2.
Figure 3. Two patterns of time preference in Hayek’s model
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Table 2. A summary of Hayek’s model (the effects of the typical changes are those that occur under the assumptions of a concave productivity curve and of a marginal time preference that decreases with wealth)
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1.3 Garrison’s Model
The models of Böhm-Bawerk and of Hayek rest upon an optimization process (graphically: a tangency between curves). Garrison’s model, on the other hand, rests upon the equalization between a supply and a demand (graphically: a point of intersection between two curves). Here, equilibrium is determined on a generalized loanable funds market.This market is generalized in the sense that it includes, not only business lending and borrowing in the strict sense, but also “retained earnings and saving in the form of the purchasing of equity shares” (Garrison 2001, 36). The intersection of the supply of and demand for loanable funds displays the equilibrium values of the interest rate and of the gross investment spending. These values are then used to determine the shape of a Hayekian structure of production, through the use of the production possibilities frontier (PPF) of the economic system (see Figure 4). This frontier indicates the “fundamental trade-off between consumer goods and capital goods” (Garrison 2001, 41): a greater investment during the current period requires a lower consumption, and a lower investment allows for a greater current consumption. For an equilibrium amount of investment Ie as determined on the loanable funds market (bottom-right quadrant), the PPF indicates the corresponding equilibrium amount of final consumption Ce, and from there on the Hayekian structure of production is itself determined (top-left quadrant).
Figure 4. Garrison’s model (adapted from Garrison 2001, 50)
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The typical changes analyzed by Garrison are (i) a technical progress and (ii) a lowering of time preference (there is no mention in his presentation of a change in the aggregate supply of labor). Let us begin with technical progress. If this progress “affects all stages of production directly and proportionally,” then “Investment, output, income, consumption, and saving would all rise together without putting pressure one way or the other on the rate of interest” (2001, 58). If, on the other hand, the technical improvement “is usable only in one or a few stages,” then the interest rate is impacted: first, the demand for loanable funds increases and the interest rate rises, as entrepreneurs “seek to take advantage of [the] new technology”; then, as incomes increase due to the enlarged investment, the supply of loanable funds also increases, and the interest rate falls; equilibrium aggregate investment Ie necessarily rises, but the resulting effect on the equilibrium interest rate ie is indeterminate since the effects of a higher demand for and a higher supply of loanable funds balance one another. Simultaneously, the PPF shifts outward since the economic system has become more productive, so that the amount of final consumption and the period of production also rise. In the case of a lowering of time preference: the supply of loanable funds shifts to the right, since people are willing to lend and invest more, but the demand does not move. As a consequence, the equilibrium interest rate diminishes, equilibrium investment increases, consumption falls, and the structure of production becomes more roundabout.The lengthening of the structure increases the productivity of labor and will eventually cause an outward movement of the PPF, but Garrison does not illustrate this effect. Garrison’s model is summarized in Table 3.
Table 3. A summary of Garrison’s model
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- VIENNA, WE HAVE A PROBLEM After this review of the Austrian models, the first and most obvious remark is that they are inconsistent with each other. In the case of the implementation of technical progress, for instance, Böhm-Bawerk’s model concludes that the interest rate will rise, while according to Hayek’s model it will rise first and then fall more than it has risen (under the assumption that time preference diminishes with wealth), and in Garrison’s model it can either rise or fall. In the case of a lowering of the preference for the present, all the models conclude that the interest rate falls and that investment necessarily increases. However, even when the conclusions converge they are deduced from incompatible premises, and this is the deeper problem that will be investigated hereafter. In order to carry out the comparison between these models, we are going to distinguish between the “productivity” models of Böhm-Bawerk and of Hayek on the one hand, and the “demand and supply” model of Garrison on the other. The comparative analysis will be carried out first between the “productivity” models, and then across the two kinds of models.
2.1 The “Productivity” Models
In both Böhm-Bawerk’s and Hayek’s models, productivity plays a key role and the convergence towards equilibrium takes place through a step-by-step optimization process, but there are significant differences between them. The first and main one pertains to intertemporal choice. In the two models, the economic agents make intertemporal decisions, but not at all of the same kind. In fact, while Hayek’s model is built upon a genuine intertemporal choice, Böhm-Bawerk’s rests upon what can be called a “pseudo” intertemporal choice. The actors in Hayek’s model face a trade-off between present and future consumption. If they want to consume more now, they must decumulate capital, and the less capitalistic structure will provide a smaller output and consumption in the future. Conversely, if they sacrifice a part of their present consumption and invest this net saving, then capital is accumulated, and the more capitalistic structure will provide a larger output and consumption in the future. There is of course nothing surprising or unusual in this kind of very basic intertemporal arbitrage. However, when we turn to what Böhm-Bawerk calls the “exchange” of present against future goods by capitalists, we realize that the phenomenon he is talking about is completely different.Böhm-Bawerk uses the word “exchange” many times in his chapter on “The Rate of Interest,” for instance in the very first sentence that reads: “The exchange of present goods for future goods, which constitutes the source of the phenomenon of interest, is merely one special case under the rubric of the exchange of goods in general” ([1889] 1959, 347). Here, the capitalists “exchange” present goods (present wages) against the goods that will be produced in the future with the help of the hired labor. In these exchanges, the capitalists invest the same amount at the beginning of a period (the wage), and they can get, over the period, different levels of interest rate according to the length T of the structure of production. It so happens, in the framework of the model, that there is a period of production that brings the highest interest rate (and also interest), and they choose this period. The crucial point is that the capitalists choose the highest interest that they can get at the end of each period, while their investment at the beginning of this period is fixed. This means that they do not choose between present and future goods, but rather between future goods available at the same moment (at the end of the period): at this moment, the capitalists can get more or can get less, and choose more over less. This choice cannot appropriately be considered as an intertemporal choice because it is made between options available at the same moment in time. Whether the period of production is longer or shorter does not require a greater or smaller sacrifice from the capitalist. There is no trade-off between present and future consumption. While the exchange in Hayek’s model is truly intertemporal, in Böhm-Bawerk’s it only appears, but is not, intertemporal.
The second significant difference between the two models has to do with the roundaboutness of the production process. The period of production is a pillar of the Austrian theory of capital, according to which capital accumulation takes place through a lengthening of the structure of production. Böhm-Bawerk’s model explicitly takes this length T into account as an endogenous variable. The period of production thus plays a key role in his formalization. Hayek (1941, 60) accepts the “roundaboutness” theory but maintains that it is not applicable in the framework of his model. The reason is that in his model “there is only one possible period of investment” (1941, 221), and as a consequence there cannot be any change in the duration of the period of production: capital accumulation takes place laterally, through the addition of similar processes of identical length, not longitudinally. His model indeed requires that, when an extra saving is invested, the increase in the production of consumption goods occurs in the very next period. Now, when the period of production lengthens, the reorganization of the structure extends over several periods, which means that a number of periods elapses before the eventual increase in the production of consumption goods. But such a waiting cannot happen in the framework of the model, which requires that the production of consumption goods increases in the period immediately following the period when the net saving is invested. Hayek’s model therefore does not integrate the phenomenon of roundaboutness that is the fundamental law of the Austrian theory of capital.This impossibility to integrate the phenomenon of roundaboutness is (in our opinion) the reason why Hayek did not try to combine his theory of the interest rate of The Pure Theory of Capital (1941) with his famous “triangle” of Prices and Production ([1931] 1935). When the economic system is depicted as a triangle, capital accumulation takes place through a lengthening of the overall period of production: the triangle becomes thinner and longer. This “longitudinal” or “vertical” accumulation of capital is incompatible with Hayek’s theory of the interest rate. To sum up, when compared to Böhm-Bawerk’s model, Hayek’s one offers a much more appropriate formalization of intertemporal choice, but uses a theory of capital accumulation that is not the core theory of the Austrian School.
2.2 Across “Productivity” and “Demand and Supply”
The “productivity” models are well suited for the study of changes that affect the real output, such as technical progress and an increase in the supply of labor: suffices to move the productivity curve and investigate the ensuing convergence process. The “supply and demand” model of Garrison, on the other hand, is especially appropriate for the study of lending and borrowing. Two questions now deserve to be answered. First, how does this “supply and demand” model address the issue of productivity? And second, are the “productivity” models able to integrate the phenomenon of lending and borrowing?
Can productivity be taken into account in the “demand and supply” model? Productivity has to do with quantities of goods, i.e. with real values. In Garrison’s model, there is an element that shows the real final output, namely the production possibilities frontier (PPF). Technical progress simultaneously affects the PPF and the loanable funds market. The PPF moves upwards, since for any level of investment I, the real final output Cr is now larger. In parallel, the supply and demand curves increase, simultaneously if technical progress is implemented all along the structure of production, and sequentially if it is implemented at one stage only (see Subsection 1.3 above). This “supply and demand” model can therefore analyze the productivity effects, even though its theory is in this case more convoluted than those offered by the “productivity” models.
This is the place to say a few words about the comparison between the Garrisonian PPF and the Hayekian productivity curve. These two curves bear a superficial resemblance, as they are both concave curves that relate consumption to investment. However, the two constructs are very different from each other. The Hayekian productivity curve is an intertemporal construct that shows how future consumption will change following a current net saving or dis-saving. This productivity curve therefore shows how a current net saving (for instance) turns into an increase in future consumption. Garrison’s PPF, on the other hand, is an instantaneous construct that shows how a current net saving implies a decrease in current consumption. Another difference is that the Hayekian productivity curve is a barrier that the economic system cannot cross, while the Garrisonian PPF is a boundary that can be crossed: the economic system can move beyond it. Garrison (2001, 70) defines the PPF as “sustainable combinations of consumption and investment,” so the economic system can indeed produce an amount that goes beyond the frontier if part of the capital is consumed.
The “supply and demand” model can take productivity into account, but can the “productivity” models integrate the phenomenon of lending and borrowing? The answer, in our opinion, is no. Hayek’s and Böhm-Bawerk’s models are exclusively based upon productivity. They have no place for a loanable funds market in which the economic agents supply or demand various amounts of present goods according to the level of the interest rate. Hayek (1941) never mentions loans in the two chapters of the book in which he develops his model. Böhm-Bawerk ([1889] 1959, 369) takes consumer loans into account, but not in his basic model, since the latter only features the wage and productivity of capital. He analyzes the demand for consumer loans separately, as an additional and specific force that impacts the interest rate and the structure of production: the economic agents who ask for consumer loans compete with workers to get a part of the subsistence fund; the more intense the demand for consumer credit, the higher the interest rate, and the shorter the structure.In the graphical representation of Böhm-Bawerk’s model (see Figure 1), the effects of the emergence of a demand for consumer loans can be visualized as a downward movement of the hyperbola wT = 2K/N, since this demand reduces the amount of capital K available for productive purposes.
Leaving aside consumer loans and focusing on the more relevant phenomenon of productive loans, a follow-up question arises: is it a serious defect for these “productivity” models that they do not integrate loans to producers? The answer depends in turn on the answer to another question: how significant is the role of loans to producers in a basic macroeconomic model? In the context of such a study, investors do not face any uncertainty, and have thus no reason to prefer less risky loans to more risky equity. Furthermore, there is no money creation by banks building additional credit (loanable funds) upon fractional reserves. It appears, therefore, that productive loans would play a secondary role in the study of the determination of investment and the interest rate. The fact that the “productivity” models cannot explicitly take these loans into account is therefore not at all a critical flaw. Furthermore, a developed economic system can be conceived without any loans, but not without any productivity of capital, so that the latter is more important from a theoretical viewpoint.In the context of his discussion of the tendency towards an equilibrium, Hayek (1941, 266) writes:We might conceive a society where the lending of money (at least at interest) was prohibited and where nevertheless, so long as the possibility of spreading investments by means of partnerships, joint-stock participation, etc., existed, the rate of return on investment would be uniform throughout the system. The rate of return on investment as determined by the price relationships between capital goods and consumers’ goods is thus prior to, and in principle independent of, the interest on money loans, although, of course, where money loans are possible, the rate of interest on these money loans will tend to correspond to the rate of return on other investments (our emphasis). Hayek does not clarify what he means by the rate of return on investment being “prior to” the interest on money loans, but he is likely talking of a historical and a theoretical priority. Decades before, Fetter ([1914] 1977, 234) argued that “capitalization” (interest on investment) is both historically and logically antecedent to “contract interest” (interest on loans).<
In conclusion, there are bridges between a “demand and supply” model such as Garrison’s and the phenomenon of productivity. The relationship between the “productivity” models and the phenomenon of productive lending and borrowing is more problematic, and has not been investigated either by Böhm-Bawerk or by Hayek in the framework of their “productivity” models.
- SOME COMMON FEATURES OF THE AUSTRIAN MODELS Even though the three models widely diverge in their specifics, at a more general level they share a number of significant characteristics.
First, they all implicitly or explicitly accept the validity and relevance of a “macro” approach in the realm of economic analysis. The idea of an “Austrian macroeconomics” may at first sight seem problematic and even paradoxical, on account of the importance that the economists of the Austrian School have attached to subjectivism and individual action since the seminal contribution by Menger ([1871] 1976). Now, as much as the proof of the pudding is in the eating, the proof of an Austrian macroeconomics is in the models presented above. Horwitz (2000, 1) writes that “In the eyes of many economists, Austrians are seen as rejecting the whole concept of macroeconomics in favor of a focus on microeconomic phenomena such as price coordination and entrepreneurship.” He adds that “there is an Austrian macroeconomics that is alive and well” (2000, 2), pointing to the study of topics such as money, banking, and the business cycle. This paper shows that Austrian macroeconomics is not limited to the theories of monetary disequilibrium and of cyclical fluctuations. It also covers much more elementary topics such as the determination of the static equilibrium interest rate and distribution between capitalists and workers. Like Horwitz, Hülsmann (2012) recognizes the existence of an Austrian macroeconomics. He notes that before Garrison’s first contribution (Garrison 1978), “the very expression Austrian macroeconomics was considered an oxymoron” (2012, 46) because the word macroeconomics was associated “with positivistic and mercantilist ideas,” ideas to which the Austrians were—and still are—strongly opposed. However, it can be argued that the Austrian tradition in macroeconomics was not born in the 1970s, but goes way back to the end of the nineteenth century.
The second common feature of these Austrian models is that they all have, in one way or another, a subjectivist foundation in human action. In Böhm-Bawerk’s model, the convergence process is driven by the capitalists aiming at maximizing the interest rate, and also competing with each other to invest their whole capital. Hayek’s model is formalized around the intertemporal choice of a Robinson Crusoe or a collectivist dictator. Garrison’s model is based upon a generalized loanable funds market in which the individual actors interact. Since the appearance in the 1930s of a macroeconomics severed from any micro-foundations (Frisch 1933), the Austrian scholars have ceaselessly criticized this kind of approach. Hayek was one of the earliest opponents of this search for relationships between aggregate statistical constructs,“In fact, neither aggregates nor averages do act upon another, and it will never be possible to establish necessary connections of cause and effect between them as we can between individual phenomena, individual prices, etc.” (Hayek [1931] 1935, 4–5). He expressed the very same thought in his last book, defining what he calls “macro-economics” as the search for “causal connections between hypothetically measurable entities or statistical aggregates,” and stating that it is a “delusion that macro-economics [in this sense] is both viable and useful” (Hayek 1988, 98). but his attack should not be understood as a criticism against any and all kind of macroeconomic investigation. The Austrian models do not suffer from the defects of the purely holistic macroeconomics that he strongly condemns. In the distinction elaborated by Lachmann (1973) between “formalism” and “subjectivism,” these models clearly belong to the latter category. Lachmann defines “formalism”—an approach with which he disagrees—as “a style of thought according to which abstract entities are treated as though they were real.” He then defines “subjectivism” as “the postulate that all economic and social phenomena have to be made intelligible by explaining them in terms of human choices and decisions” (1973, 9–10). The Austrian macroeconomic models indeed rest upon the subjectivist approach, in line with the Mengerian tradition of methodological individualism.
Third, all the models use very similar simplifications in order to make the analysis of the economic system manageable. These simplifications are too numerous to be listed exhaustively, but here are some of the most significant. The economic system produces a homogenous consumption good or basket. The capital goods, on the other hand, can be different from the consumption good, and to this extent these models are not as simple as the standard neoclassical model of Solow and Swan, in which there is only one good used both as a capital and as a consumption good. There are two kinds of factors of production, namely labor and capital goods (in the Böhm-Bawerkian sense of produced factors of production). In the more general case, there are three kinds of factors, labor, capital goods and land. If land is taken into account, then the corresponding (unproduced) natural resources are not exhaustible: if there were an exhaustible resource, then a static equilibrium could not occur because the quantity of one of the productive inputs would diminish over time. When the effect of technical progress is analyzed, the discovery of more efficient techniques of production is free, and these more advanced methods increase final production as soon as they are discovered and implemented.It would be more realistic to suppose that there is a delay between the implementation of new techniques and the eventual increase in the production of consumer goods. If the progress takes place at a stage far away from final consumption (for instance an improvement in the methods of extraction of deposits), then it could take several years before the increase in the final output occurs. The functioning of the price system that reallocates the factors of production where they are the most useful is taken for granted, and quickly adjusts the structure of production after an exogenous shock. Finally, these models eliminate uncertainty, and with it the entrepreneurial function. The absence of uncertainty gives them a “mechanistic” appearance that is discordant with the work in the Austrian paradigm that is more focused on the way the market process allows the agents to cope with radical ignorance.As Lachmann ([1991] 1994, 278) puts it, “In its essence Austrian economics may be said to provide a voluntaristic theory of action, not a mechanistic one. Austrians cannot but reject a conceptual scheme, such as the neoclassical, for which man is not a bearer of active thought but a mere bundle of ‘dispositions’ in the form of a ‘comprehensive preference field.’” This mechanistic aspect, however, seems to be the price to pay for the high degree of simplification required in order to cope with an economic system as a whole.
On the theoretical side also, these models bear an undeniable resemblance. As far as production is concerned, it can only grow if the quantities of factors increase or if better techniques are implemented. The increase in the quantities of factors can be either exogenous in the case of the original factors labor and land, or endogenous (through saving) in the case of capital goods. In all these models, the crucial theoretical problem that has to be solved is the problem of the determination of the interest rate. In fact, for two of the three models (Böhm-Bawerk’s and Hayek’s), the essential reason they were developed was to get a theory of the forces that lead to the determination of the level of the interest rate. In the case of Hayek, the problem was to weigh the relative influence of productivity and of time preference on the height of the interest rate. Another major theoretical similarity is the kind of shocks whose effects upon equilibrium and distribution can be analyzed, namely a change of time preference (capital accumulation or dissipation), technical progress, and a change in the supply of labor. A last theoretical common point between the models is the use of the Austrian structure of production and of the related Böhm-Bawerkian theory of roundaboutness. The only model that does not resort to either of these two elements is Hayek’s model, for reasons indicated above (see Subsection 2.1). It is surprising that Hayek’s model is the one that does not make use of the most famous construct in Austrian macroeconomics, namely the Hayekian triangle developed by Hayek himself ([1931] 1935).
Finally, from an epistemological viewpoint, the three Austrian models all exemplify the same kind of endeavor. They are not intended to be tested against empirical observations. They are not meant to be calibrated to match historical macroeconomic data in order to determine the value of their parameters.We are not claiming that it would be impossible to relate in one way or another these models to macroeconomic data, but it certainly has never been attempted and was not the reason why they were developed in the first place. Rather, they are conceived as intelligibility models that aim at clarifying some of the most basic economic questions in a very simplified setting. This clarification rests upon the logic of action, and has nothing to do with the empirical corroboration of hypothetical laws. These models therefore follow an epistemology that is not the one used in the experimental sciences.Hayek (1952) and Mises (1962) offer classic statements, from an Austrian perspective, of the epistemological specificity of the social sciences vis-à-vis the natural sciences.
For all these reasons, in spite of their divergences, the three Austrian models are part of the same family. They can be considered as declinations or exemplars of a common approach to basic macroeconomics, illustrating the search for simple frameworks that illuminate the determination of the interest rate and the distribution of the net output. All these attempts agree on the purpose of a straightforward and relevant macroeconomic model in terms of equilibrium analysis and response to typical shocks.
- WHY NO SINGLE MODEL DOMINATES Up to this point, it has been established that the Austrian macroeconomic models are contradictory in their premises and conclusions, but bear a family resemblance. The question remains as to why none of them has managed, at least until now, to dominate the scene within the Austrian School, and by “dominate” we mean: being generally accepted within the School as a sound theoretical foundation.
Böhm-Bawerk’s model was published in 1889, and was mathematically formalized a few years later by Wicksell ([1893] 1970). There is, however, no trace of this model in Wieser’s treatise ([1914] 1927), nor in Strigl’s main book on capital ([1934] 2000). The model was revived by Dorfman (1959), and the last specific reference to it by a major Austrian economist is found, to the best of our knowledge, in Kirzner (1966).Blaug ([1962] 1978) offers a detailed presentation of the model in the chapter devoted to the Austrian theory of capital and interest. In the meantime, the two main Austrian economists of the twentieth century, namely Mises and Hayek, had both aimed severe criticisms at Böhm-Bawerk’s approach of the theory of interest. Their criticisms are not consistent with each other, though, and furthermore do not rest upon a detailed examination of the model itself. Rather, they target some of the most general features of Böhm-Bawerk’s approach. Hayek (1941) criticizes the simplistic assumptions made by Böhm-Bawerk when he treats the quantity of capital and the period of production as purely technical data.“As will appear later in more detail, the quantity of capital as a value magnitude, no less than the different investment periods, are not data, but are among the unknowns which have to be determined.” (Hayek 1941, 192) Mises is extremely severe vis-à-vis the Böhm-Bawerkian concept of “average period of production,” which he labels an “empty concept.”“The length of time expended in the past for the production of capital goods available today does not count at all. These capital goods are valued only with regard to their usefulness for future want-satisfaction. The ‘average period of production’ is an empty concept.” (Mises [1949] 1998, 486) He also totally rejects the productivity theory of interest that forms the core of Böhm-Bawerk’s model. In this regard, the opinions of Mises and of Hayek diverge: Hayek considers Böhm-Bawerk’s criticism of earlier productivity theories as “mistaken,”“[Böhm-Bawerk’s] effective, although I think mistaken, critique of the earlier productivity theories of interest had the effect of causing later development to centre [sic] increasingly round the ‘psychological’ or ‘time-preference’ element in his theory rather than the productivity element.” (Hayek 1941, 42) while Mises lauds how “brilliantly” Böhm-Bawerk refuted these first productivity theories.“... Böhm-Bawerk in the elaboration of his theory did not entirely avoid the productivity approach which he himself had so brilliantly refuted in his critical history of the doctrines of capital and interest.” (Mises [1949] 1998, 486) So they both point out what they believe to be insurmountable flaws in Böhm-Bawerk’s theory. The latter’s model, therefore, could not be accepted by the followers either of Mises or of Hayek, which pretty much means that it could not be accepted by anyone in the Austrian School from the mid-twentieth century on.
In the 1970s, Faber (1979) developed a “neo-Austrian” approach to the theory of capital. After an in-depth analysis and criticism of Böhm-Bawerk’s model, Faber makes use of a mathematical model of the economic equilibrium elaborated by von Neumann (1945–46). This model rejects the concept of an average period of production, but it can be infused nonetheless with the Böhm-Bawerkian theory of roundaboutness. Faber is able, with his neo-Austrian version of von Neumann’s model, to investigate the cases of a two-period two-sector economy, and then of a multi-period (with a finite horizon) economy.The author wishes to thank an anonymous referee for the reference to and remarks about Faber’s work.
Hayek’s model has recently been brought to light by Molavi Vasséi (2015) and Fillieule (2017). White (2007) also devoted a few paragraphs to it in his “Introduction” to the new edition of Hayek (1941). There are a number of reasons why this model has not been used to build a cumulative tradition. The first one is that Hayek’s book failed to have a significant following in the Austrian School, in the sense that nobody tried to develop capital theory along the lines first set out in this book. Furthermore, the model does not deal with the core topic of the 1941 book, namely capital theory. An off-topic model in an idiosyncratic book had little chance to make an impression.In his recent presentation of The Pure Theory of Capital, Steele (2014) does not expound this model at all. A second reason is that the model was not conceived, and also not really recognized, as a macroeconomic model. In his ([1936] 2015) paper, Hayek insists upon the way his model formalizes time preference, and claims that the concept of “constant tastes” failed to be correctly understood by Böhm-Bawerk and by Schumpeter. Hayek ([1936] 2015, 36) then explains that “we... have to represent constant tastes by declaring the indifference map of the individual (or the indifference maps of all the individuals) to be the same at every moment.” His model indeed solves the problem of formalizing “constant tastes” as a pattern of intertemporal indifference curves that remains the same at the successive periods. But as a result of this presentation, the much wider range of the model may have been neglected. There were also probably more technical reasons, such as the hypothesis of a constant marginal productivity (which deprives the model of much of its appeal, since it restricts the acceptable kind of time preference pattern to the implausible case of a marginal time preference that increases with wealth), and such as the fact that Hayek did not systematically try to investigate the effects of changes in time preference, technology, and supply of labor. A major reason for the neglect of this model is that in the United States, where the Austrian School experienced a renaissance in the second half of the twentieth century, the scholars adopted the Fetter-Mises subjectivist theory of interest instead of a productivity theory. The time preference theory of interest was endorsed by Rothbard ([1962] 2009), Garrison (1979), Kirzner (1993), and other authors (see Pellengahr 1996). Hayek (1941), on the other hand, very explicitly chose the productivity explanation of interest, even though he thought that time preference could also play a (minor) role in the determination of interest.“Of the two branches of the Böhm-Bawerkian school, that which stressed the productivity element almost to the exclusion of time preference, the branch whose chief representative is K. Wicksell, was essentially right, as against the branch represented by Professors F. A. Fetter and I. Fisher, who stressed time preference as the exclusive factor and an at least equally important factor respectively.” (Hayek 1941, 420) As a result, his model—interpreted by Hayek as a validation of the productivity theory of interest—was largely overlooked.
Garrison’s model (2001) attracted a lot of attention within the Austrian School as soon as it was published. The reason is that this author had provided for more than two decades some of the most important macroeconomic work of the school (see for instance Garrison 1984). The book (not just the model) was received with great expectations by the Austrian scholars, but the reviews that were published in the two major Austrian journals were not entirely positive. In the Review of Austrian Economics, Oprea and Wagner (2003) criticized Garrison’s book for being dated, reviving discussions from the 1960s, and for not taking into account the more recent mainstream macroeconomic paradigms. The Quarterly Journal of Austrian Economics devoted a whole issue to the analysis and commentary of the book (Thornton 2001). While more positive in tone than Oprea and Wagner’s review, a number of criticisms were raised. The comments about the comparison drawn by Garrison between his “capital-based macroeconomics” and the macroeconomics of Keynes and Friedman do not concern us in this paper, and neither do the comments about the theory of the business cycle. The graphical construct is the focus here, and it was criticized by Hülsmann and by Salerno. Hülsmann (2001, 40) notes two inconsistencies in the diagrams displayed by Garrison (see Figure 4 above). First, there is a discrepancy between the nature of the variables in the top part of the diagram, namely between the real consumption on the vertical axis of the PPF and the nominal consumption on the vertical side of the Hayekian triangle. Second, there is a temporal discrepancy between the two horizontal axes, the bottom horizontal axis showing the current investment that will produce the future capital goods, and the top horizontal axis showing these future capital goods on the PPF. Salerno (2001) criticizes another aspect of the model, this time pertaining to the theory of growth. Garrison (2001, 54) claims that a “secular growth” can occur “without having been provoked by policy or by technological advance or by a change in intertemporal preferences.” This secular growth is simply the result of “the ongoing gross investment,” which “is sufficient for both capital maintenance and capital accumulation.” Salerno points out that the Austrian theory asserts, rather, that the growth brought by a net investment ends up in a stationary equilibrium and cannot lead to an indefinite growth.Writes Salerno (2001, 45): “However, in Austrian capital theory, each dose of net investment, ceteris paribus—and after a transition period during which the appropriate resource reallocations have been completed—brings about a stationary economy in which the new higher level of gross investment and the elongated structure of production is just sufficient to support a definite increase in the flow of consumer goods. As long as gross investment is maintained at its new higher level, the output of consumer goods per period will remain constant.” See also the recent qualified defense of Garrison’s theory of secular growth by Murphy (2017). So, even though Garrison’s diagrammatic exposition of Austrian macroeconomics was generally praised as a pedagogical tool (and still is“[P]erhaps the primary virtue of Time and Money is its exposition of capital-based macroeconomics in terminology and graphs that non-Austrian economists can understand.” (Murphy 2017, 353)), some of the reviewers were skeptical about parts of the theoretical underpinnings of the model.
CONCLUSION This paper has attempted to tell the little-known story of the basic Austrian macroeconomic models, models spanning from the end of the nineteenth century to the beginning of the twenty-first. After a presentation of each model, a detailed account of the differences between them has been provided. The main results of this investigation can be summarized as follows. (i) There exists an Austrian macroeconomics, even at a quite elementary level that does not take uncertainty and monetary disturbances into account. (ii) This macroeconomics is embodied in formal models that have been presented graphically as well as mathematically. (iii) These models are not consistent with each other. (iv) The inconsistencies between them are mainly due to disagreements on the theory of the interest rate. (v) Beyond these theoretical contradictions, these models all try to solve the same kind of problems by using of the same (actionist) methodology. (vi) The continuing search for a basic macroeconomic model, from the birth of the Austrian school until today, shows the importance and relevance of this topic from a theoretical viewpoint. (vii) Nevertheless, very few discussions, if any, have taken place in the history of this school on the relative merits of the different models. From a history of thought perspective, this study shows that in macroeconomics just as in other areas (banking, for instance), the Austrian School is not monolithic but has been traversed by deep tensions, some of them still unresolved.
Abstract: Abstract: This paper analyzes Brazil’s 2004–16 business cycle, which subsumes what is now regarded as the nation’s most severe macroeconomic recession in more than a century. During the steep recession, which stretched over more than two years, national production at one point fell 3.8 percent per annum while the unemployment rate rose from 4.6 to as high as 11.9 percent. This study, after delineating its methodology, examines the behavior of different Brazilian macroeconomic aggregates during the cycle. These aggregates include GDP, the money supply, interest rates, savings, industrial production of higher- and lower-order goods, and inflation. Also examined are the Brazilian government’s interventions that rearranged Brazil’s structure of production and ignited an unsustainable boom, the role of price controls in prolonging economic recovery, and the recovery per se using the theoretical lens of the Austrian-adjustment process. Finally, empirical data from the recent Brazilian cycle will be analyzed in light of the predictions of Austrian business cycle theory (ABCT). The data were found overall to support the theory.
central bank price controls monetary policy business cycle brazil JEL Classification: E14, E21, E31, E32, E51, E52 Henrique Lyra Maia (henriquelyramaia@gmail.com) is a doctoral student at FUCAPE Business School (Vitoria, Brazil). Dale Steinreich (dsteinreich@drury.edu) is an instructor of economics at Drury University. Bruno Saboia de Albuquerque (brunosaboia@alu.ufc.br) is a researcher in economics at Universidade Federal do Ceará.
The authors wish to thank the Grant Aldrich Committee of the Austrian Economics Research Conference (AERC) 2018 for making an earlier version of this paper a Grant-Aldrich Prize finalist, and Timothy D. Terrell, Joseph T. Salerno, Robert Barclay, and two anonymous referees for their encouragement and guidance.
I. INTRODUCTION It has long been recognized in Brazil that the nation’s economy has tremendous difficulty sustaining long-term growth. Brazilian economists jokingly call this “the flight of the chicken,” referring to the fact that among birds, chickens are only capable of flying a maximum distance of a few hundred feet. In the same way, Brazil’s economy typically enters a period of impressive-looking growth before this growth quickly gives way to crisis or stagnation. This has happened over and over again.
The central macroeconomic debate in Brazil has been about the real causes of the nation’s lack of sustained growth. Motivated by this discussion, this article will deconstruct Brazil’s latest economic boom and bust in light of Austrian business cycle theory (ABCT), using ABCT to explain the recent cycle’s causes and why this period became yet another “flight of the chicken.”
The recent crisis carries a special meaning for Brazilians. It is the most severe recession since GDP measurement was introduced in Brazil in 1901. It persisted over two full and consecutive years, inflicting an annual decline in GDP of more than 3 percent.As the recession entered 2017, the authors ended their analysis for this study at December 2016. Subsequent sections in this article will provide deeper analysis of the data discussed in this paragraph. In the boom, the unemployment rate fell to 4.6 percent before skyrocketing to 11.9 percentFor these data, the authors used two different series because one was discontinued in February 2016. For the boom phase, the Central Bank of Brazil’s (Banco Central do Brasil, BCB for short) series number is 10777. The series for the bust phase is 24369. during the bust. This was the most agonizing crisis for Brazilians in at least 115 years (Cury and Silveira 2017).
The most important features of ABCT were first introduced by Mises (2008, 2009), amended with lengthy contributions from Hayek (1931, 1933, 2008), Rothbard (2000, 2009), and Garrison (1978, 1997, 2001, 2004, 2012). Recently, another set of articles was published, each article making new contributions (Carilli and Dempster 2001, Evans and Baxendale 2008, Macovei 2015, Engelhardt 2012, Salerno 2012, Giménez Roche 2014). For Brazil’s economy during the 2004–16 business cycle, data for all the macroeconomic variables relevant to ABCT have been obtained.
This article is divided into nine sections. After this brief introduction (section one), section two will introduce ABCT and its main theorists. Section three will explain the methodological aspects of this study while section four will deconstruct the recent Brazilian cycle into distinct phases for a better understanding of the whole. For the reader, this fourth section is key to interpreting and understanding data presented later in the article. Sections five and six will be dedicated to explaining in detail phase two (“reset” and the New Matrix boom) and phase three (bust) and how government intervention re-arranged Brazil’s structure of production. Section seven will analyze the inflation component of the business cycle and how government price controls postponed Brazil’s recovery. The eighth section will summarize all the results from the data and make some final observations. Finally, the last section (nine) will conclude this study.
II. AUSTRIAN BUSINESS CYCLE THEORY (ABCT) Economic transactions occur when individuals pursue their objectives (Mises 2008, 11). Every individual analyzes the costs and benefits of searching for information and gaining knowledge to achieve his or her goals (Mueller 2014). However, individuals do not possess all the information available in the economy. Each individual only retains the bits of knowledge that he or she uses for his or her own purposes (Hayek 1945).
Considering that economic transactions and knowledge are dispersed, it is difficult to conceive of how markets can act in synchrony over the long term. People have diverse goals and act in different ways. As a consequence, only small clusters of errors are theoretically possible, restricted to relatively few firms (Rothbard 2009, 17). It would be just about impossible for all firms in the entire economy to go bankrupt in unison. In other words, when business cycles—a boom followed by a bust--occur, it is rational to attribute an external variable as the force that is influencing individuals to engage in systemic entrepreneurial error (Rothbard 2000, 9). Hence, in an unhampered market a massive crisis will not be possible (Mises 2008, 562).
Instead of boom and bust, economic development aims for a more sustained growth model. To avoid creating cycles and systemic economic instability, economic transactions must be built upon stronger foundations. There are three major sources of sustainable growth for an economy. The first is increasing levels of voluntary savings from individuals. When true voluntary savings are accumulated, consumer time preferences guide entrepreneurial action towards projects in alignment with consumer preferences (Manish and Powell 2014).
In the aggregate, extra savings reallocates capital that would have been spent on consumption to loanable-funds markets for investment projects (Garrison 1997). With an increase in the supply of loanable funds, the real interest rate falls and more capital projects are undertaken. Capital-intensive projects are very interest-rate sensitive. Many projects can become economically viable when capital becomes cheaper. When this happens, the structure of production changes to a more lengthy (Hayek 1936) and prolific (Hayek 2008) modus operandi. In the long run, the more productive investment in roundaboutThis term is usually used in capital theory to denote a more capital-intensive method of production. Sometimes Hayek also used “capitalistic methods,” “roundaboutness,” or “roundabout methods of production.” These terms are synonymous (Hayek 2008). methods of production will more than compensate for the fall in consumer prices as a consequence of less short-term consumption (Hayek 1931). When a nation invests in capital projects, its production-possibilities frontier is extended and this extension yields a more solid foundation for future growth (Garrison 2012).
When individuals in a nation have not saved enough such that interest rates in loanable-funds markets fall, external savings (foreign-direct investment) can be another route to sustainable growth (Mises 2006, 75). Foreign investors who have the savings to undertake capital projects can fill in the domestic gap in savings needed to initiate or maintain sustainable growth.
The other way to achieve sustainable growth is with more efficient methods of production and intangible capital (Young 2009a). Technology would certainly mean consuming less resources to produce more output, leading the economy to extend its production-possibilities frontier (Garrison 2012). Productivity can lead to sustainable growth because individuals can produce a larger quantity of output with less input, which ultimately increases individuals’ earnings. It is possible for entrepreneurs to engage in new capital projects while consumption is expanding (Mises 2008, 512–13).
Even if time preferences stay constant, with more productivity more money becomes available for entrepreneurs to engage in more projects, leading to sustainable economic growth (Young 2009a, Engelhardt 2009, Young 2009b). Despite the fact that sustainable growth can be created by increasing productivity, if time preferences are not lowered, entrepreneurial projects will encounter limits. In other words, for a longer and more productive structure of production, individuals’ time preferences will have to be lowered (Salerno 2001, Cochran 2001). Higher productivity increases wealth, which in turn can motivate individuals to lower their time preferences (Block, Barnett, and Salerno 2006). However, it might be the case that individuals can spend all their extra earnings and continue to increase their time preferences. As a result, increased productivity can only lead to a fall in interest rates if individuals, with higher earnings, lower their time preferences. The decision by individuals to lower their time preferences after they become more productive is a function of each individual’s preference, not a fact.
If individuals in a given society do not pursue goals that encourage greater savings and/or lower time preferences, stagnation and slow growth are the results. Changing these variables (savings/time preferences) in the direction that facilitates growth takes time and effort. If government intervenes in the form of shortcuts, the economy can be steered onto an unsustainable path (Garrison 2004). Government interventions can take myriad forms and stifle the economic development of a society (Mises 2011).
In terms of monetary policy, business cycles can be formed when government forces interest rates below their natural market level, stimulating artificial development of capital industries (Mises 2008). In addition, consumption will also be stimulated as individuals are incentivized to spend more and save less. When spending on both capital and consumption goods is stimulated by the government, a tug-of-war competition for scarce resources ensues (Garrison 2001).
The first phase of the cycle is the boom that is a result of the dual-stimulus spending on capital and consumer goods. A euphoria of prosperity will prevail (Mises 2011, 564). The new artificially lower interest rate through credit expansion drives GDP growth. Capital and consumer projects are implemented, with the former being more sensitive to interest-rate manipulation and credit expansion. Thus, capital projects begin growing at a higher rate than consumer projects (Hayek 2008).
Eventually the economy does not have all the resources to complete all the projects that are being simultaneously pursued. On the one hand, qualified labor and land are scarce resources and simultaneous competition for them will lead to rising prices in the factors of production (Garrison 2001, 72). On the other hand, capital is also a scarce resource and, when purchased with newly created money, its price rises quickly as well (Mises 2008, 550).
As a consequence of this process, nominal interest rates eventually rise because of future real losses in the value of bank loans because of inflation.This will necessitate the addition of an inflation premium onto the real interest rate to compensate for the fall in the purchasing power of the currency unit. The sum of the real interest rate plus the inflation premium is the nominal interest rate. The expected result is that capital goods will suffer disproportionately from the early reversal of this process (Mises 2008). In addition, the consumer-goods industry will also suffer from the decrease in the purchasing power of money imposed by inflation. A recession will follow and pessimistic expectations in the market will turn projects once deemed profitable into malinvestments (Rothbard 2009, Holcombe 2017). Banks will then tend to impose greater restrictions on lending because of negative expectations for the economy. The result is stagnation or a fall in credit expansion (Mises 2008, 565).
ABCT is concerned with artificially low interest rates driving not only malinvestment, but overconsumption in the inflationary boom portion of the business cycle (Mises 2008, Rothbard 2000, Hayek 2008). Its essence is the falsification of monetary calculation; it is not an overinvestment (“hydraulic”) theory of business cycles as misunderstood by a pantheon of mainstream macroeconomists from Paul Krugman and Brad DeLong to Tyler Cowen and Bryan Caplan (Salerno 2012).
When the inevitable macroeconomic bust arrives, a return to the old conditions begins through gradual market adjustments. The recession is the “healthy” phase in which the economy begins recovering if the government bows out. If the government does not cease its interventions, the recovery will stall and the recession will continue (Rothbard 2009). In summary, the recession phase is characterized by a fall in prices, a rise in the interest rate, consumer thrift, and slow sales for entrepreneurs.
III. METHODOLOGY Economic cycles occur within a period of time and in a specific geographic region. The recent cycle in Brazil occurred in three distinct phases, covering a period of approximately 13 years (2004–16) from boom to bust. GDP was used to provide a general measure of macroeconomic performance. If ABCT explains the boom and bust caused by a cluster of errors (Hülsmann 1998), then those errors will affect GDP positively and negatively during the business cycle. For that reason, the main criteria for distinguishing the cyclical phases were fluctuations in GDP, interest rates, credit expansion, industrial production of consumer and capital goods, and macroeconomic policy enacted by Brazil’s government.
After identifying the phases of the cycle, the macroeconomic variables of relevance were collated. They are as follows:
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GDP
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interest rate
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money supply
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credit expansion
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savings
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industrial production (higher-order stages)
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industrial production (lower-order stages)
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inflation
GDP of course provides a big picture view of when the crisis unfolded and why the recent cycle was the most severe in Brazil’s more-than-one-hundred years of history. It will be displayed on an annual basis. Obviously, it is expected to grow in the boom phase and fall in the bust phase.
The second variable, the real interest rate, is key for tracing credit expansion and how this expansion lead to an unsustainable boom. The expected results would be a fall in the interest rate during the boom and a rise during the bust. The third variable, Brazilian monetary aggregate M2, will track the changes in the Brazilian money supply.In Brazil, M2 is defined as it is in the U.S.: currency (coins and bills) + demand deposits + traveler’s checks + other checkable deposits + savings deposits + small time deposits + money-market mutual funds + some minor categories (Mankiw 2018, 324). We expect that this variable will grow during the boom and stagnate or decline in the bust. As for credit expansion, the fourth variable, the expected results are an expansion during the boom and a stagnation or decline during the bust.
As for nominal savings (fifth variable), there is no particular expectation about its direction in either the boom or bust phases. If there is an increase in its size during the boom, it must be less than that of artificial credit expansion.
For the sixth and seventh variables, as explained in the previous section, higher-order goods experience a higher rate of growth than lower-order goods during booms. When the bust arrives, higher-order goods production will decline at a higher rate than lower-order goods production. Capital (higher order) goods tend to have more volatile production levels than consumer (lower order) goods. In the nomenclature of statistics, capital-goods production levels have a higher standard deviation from the mean (Rothbard 2009, 19).
Finally, inflation (eighth variable) will tend to rise in the boom phase, since both capital and consumer goods are receiving major stimuli, and this in turn puts pressure on the prices of the factors of production. After first flowing into capital goods, new money raises demand downstream and eventually puts pressure on the prices of consumer goods (Hayek 2008). There must be an eventual reversal of the growth of inflation in the bust phase or a steep fall in it when adjustments instantiate into inflated prices.
Table 1 below is a summary of expected results in the variables during the boom and bust periods. As can be seen in the table, in some cases the theory does not predict any particular result.
Table 1. Expected Results (ABCT)
- No explicit prediction for this was found in ABCT but was deduced from the theory of Garrison (2001) in which it is impossible to have growth in credit markets when savings falls except in the case of government intervention. In later sections of this article, these results predicted by ABCT will be compared to the actual ones from the 2004–16 Brazilian cycle. The methodology used in this study does not involve an empirical test in the sense that hypotheses were formed and-or extraneous economic models were used to test ABCT (Hoppe 2007). The authors only wish to observe whether results consistent with ABCT occurred, assuming that no other exogenous variable(s) significantly influenced these results. Thus if a few of the observed results are not compatible with the theory, it does not necessarily mean that the theory has been refuted but rather that other variables not included in the present study may have affected the results.
Industrial production was disaggregated into specific sectors and how they behaved in the various phases of the cycle. These phases were categorized in light of the structure of production illustrated in Hayek’s triangle (Hayek 2008). The more distant from consumer goods (higher orders), the more capital intensive and time consuming the process becomes. The opposite is also true: businesses closer to consumer goods (lower orders) are less capital intensive and less time consuming. Some industries are not clear cut. For example, the construction sector has characteristics of both orders: it is close to the consumer in some transactions, absorbs significant time and capital to produce certain products in other transactions, and is very interest-rate sensitive. On balance, this sector will be classified as higher order. The data used are from the Brazilian Institute of Geography and Statistics (Instituto Brasileiro de Geografia e Estatística, or IBGE for short) and the Central Bank of Brazil (Banco Central do Brasil, or BCB for short). Both of these institutions in Brazil are (not surprisingly) government agencies. Their classifications were used and then macroeconomic sectors were designated as higher-, intermediary-, or lower-order as shown in Table 2 below.
Table 2. Classification of Brazil’s Industrial-Production Statistical Series* by Their Location in the Brazilian Structure of Production
Source: BCB Industrial Production series 21861–68. * See methodological notes (Brazilian Institute of Geography and Statistics 2004). ** This series became available in January 2012, therefore analysis will be limited. Again, despite the fact that some authors have attempted to empirically test ABCT (e.g., Luther and Cohen 2014), this study will only analyze data in light of ABCT. The authors included changes in savings and interest rates in their criteria for defining the different phases of the cycle (Garrison 2006).
IV. THE BRAZILIAN EXPERIENCE When President Lula took office in 2003, many supporters and opponents of his Workers Party (Partido dos Trabalhadores, or PT for short) were expecting that Lula would implement the agenda that PT had been preaching for several years. Since the 1990s, PT was mainly against “everything that was out there,” advocating market-unfriendly policies (Leitão 2011, 396 [authors’ translation]). With a radical-left mindset, members of the party and Brazilians in general thought that an agenda of economic intervention, such as debt default, would be enacted by the new president (Giambiagi et al. 2016, 198).
Markets were expecting a departure from the economic regime of Lula’s predecessor, Fernando Henrique Cardoso. The Cardoso administration was in compliance with International Monetary Fund (IMF) recommendations and its economic policies were christened the Macroeconomic Tripod. The Tripod, per its name, was based on three major goals: fiscal austerity, inflation control, and a floating exchange rate (Veloso et al. 2013).
However, Lula unexpectedly embraced the Macro Tripod and continued with it in his first term, which ran from 2003 to 2006 (Amorim 2016, 28). Macro-economically, the year 2003 was very turbulent for Brazil because markets were expecting an abandonment of the Tripod. The following year, 2004, is when the first continuous boom of the cycle began.
Suggested proximate causes outside of those specified in ABCT include the following. First, loose money policies in the major world economies allegedly triggered large capital inflows into Brazil. Two BCB officials (Hennings and Mesquita 2008) demonstrate that foreign direct investment (FDI), after reaching a peak of around $40 billion (U.S.) in 2001, fell to about half that in late 2003, then began strongly surging again after mid-2004, reaching around $60 billion (U.S.) in early 2008. Local equity market inflows surged from $5.4 billion (U.S.) in 2005 to $24.6 billion (U.S.) by 2007. In this exact same time interval, gross inflows surged from $32.3 billion (U.S.) to $116.6 billion (U.S.). “[N]et or gross terms, these inflows are unprecedented in the post-World War II Brazilian experience” (Hennings and Mesquita 2008, 107).
Second, BCB increased the money supply in Brazil. Third and last, government fiscal and regulatory policy added more fuel to the boom. One alleged example is a September 2003 executive order (later legislatively approved in December 2003) that authorized banks to offer loans that could be repaid through automatic payroll deductions. A study by Coelho, Mello, and Funchal (2010) found that the new law caused a significant decline in interest rates and significant increase in credit.The authors do not necessarily agree with these purported extra-ABCT causes. A planned follow-up study will explore this issue in greater detail.
Brazil’s economic cycle will be divided into three phases. Phase 1 is the continuance of the Macroeconomic Tripod (T-boom for short) by President Lula throughout his first full term and half of his second term, the years 2004–08 in which the boom began. President Lula’s first year in office was 2003, but that year was removed from this study because, as previously mentioned, it was a period of great instability which clouds the analysis.
The financial crisis in the United States which peaked in September 2008While the initial tremors of the crisis were felt in the bank runs against BNP Paribas (9 August 2007) and Northern Rock (14 September 2007), the apex of the crisis was undoubtedly the collapse of Lehman Brothers on 15 September 2008. with the failure of Lehman Brothers investment bank was the trigger that shifted the Lula administration away from the Macro Tripod. The administration’s new model, later named the New Economic Matrix, was based on five major pillars:
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Aggressive reduction of interest rates.
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Credit expansion to consumers and private enterprises through publicly owned commercial and development banks.
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Government privileges for boosting specific private companies.
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Subsidies and fiscal abnegation for specific sectors to boost the economy.
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State enterprises controlling prices and inflation.This economic plan was gradually being implemented and refined over some years, starting in 2008 and taking full form by 2011. For a timeline of this economic plan and its main pillars, see Roque (2015).
Even though all of the aforementioned interventions played a part in causing the boom and bust, this study will argue that the main causes were artificially low interest rates and accompanying credit expansion and that all other interventions were secondary in nature.
Lula’s shift between economic models will be referred to as “Reset” in this paper, an allusion to the old mindset of PT, which advocates major government interventions to steer Brazil’s economy. This second stage of Lula’s economic program contains the Reset and Economic-Matrix boom or M-boom. In other words, this paper divided the boom periods of the cycle into two parts: T-boom (Phase 1) and Reset plus M-boom (Phase 2).
Finally, the last phase (Phase 3) is the bust. Brazil’s economy shrank for 11 consecutive quarters, producing the worst crisis in the nation’s history. The second leg of the “flight of the chicken” lasted five years (2010–14) before the economy nosedived into the dark waters of deep recession.
In Figure 1 below, the blue bars evince economic growth for 2004–14. The years 2004–08 delivered a mean of 4.81 percent annual growth. The year 2009 represented mainly stagnation for the Brazilian economy. Between 2010 and the beginning of 2013, annual growth was 4.1 percent. While this Matrix-boom average is lower, it is still close to that of the T-boom phase. In the last phase (bust), there was a deep recession with 3.8- and 3.6-percent negative growth in 2015 and 2016, respectively. What is not shown in Figure 1 below is that the recession ended in the first quarter of 2017 with a positive quarterly growth rate in GDP of one percent.
Figure 1. Average Annual Growth Rate in GDP Across Brazil’s 2004-16 Business Cycle
Source: Central Bank of Brazil GDP series 7326. For the purposes of this article, it will be assumed that the Reset began after the peak of the U.S. financial crisis in September 2008 and ended at the end of 2009. The M-boom began in about January 2010 and ended in approximately February 2014. These dates are estimates because it is difficult to pinpoint with great precision when the boom and bust phases began and ended. The great precision that is lost is not relevant for the purposes of this paper. In some cases, only full years will be analyzed—the specific months that characterize each phase will be dismissed. Table 3 below specifies in detail the approximate boundaries of each phase.
Table 3. Components of the Brazilian Business Cycle (2004–16)
V. PHASES 1 AND 2: T-BOOM, RESET, AND M-BOOM One of the most important aspects of ABCT is the manipulation of the interest rate by the central bank. Figure 2 below illustrates real annual interest rates throughout Brazil’s recent cycle. In the first phase of the cycle (2004–08), the real interest rate averaged 9.18 percent per annum. During the second phase—Reset and M-boom—between 2009 and 2013, the mean real interest rate was 3.91 percent.Special System of Liquidation and Custody (Sistema Especial de Liquidação e Custódia, SELIC for short) is the system used by the Central Bank of Brazil (BCB) to implement its interest-rate policy via buying and selling government bonds. This is a difference of 5.27 percentage points, or a fall of about 57 percent. Throughout the bust, the real annual interest rate fell no lower than 4 percent.
Figure 2. Five-Year Average of Annual Real Interest Rates in Brazil (2004-08, 2009-13)
Source: Central Bank of Brazil (BCB). SELIC series 4390. For the real interest rate calculation authors used Fisher equation. For the nominal rate, authors used annualized SELIC rate and for the inflation rate authors used the IPCA 12-month inflation index for each month. The blue bars represent the average for the year. Recall that when the interest rate falls, the demands for both capital goods and consumer goods will be stimulated (Garrison 2001, 72). If the interest rate fell between the first two phases, this would lead us to expect that credit offered to businesses and consumers would enjoy strong and continued growth between the two periods.
It is interesting to note the behavior of M2 surrounding the reduction in the interest rate. Table 4 displays the compound-adjusted growth in M2 in each phase.
Table 4. Compound Average Growth for M1 and M2
Source: Central Bank of Brazil (BCB). M1 and M2 series 27791 and 27819, respectively. It is clear that the boom period had an outstanding growth rate in M2 of 20.83 percent in Phase 1 and 12.98 percent in Phase 2. Before analyzing the results, it is important to make an observation about credit markets in Brazil. Brazil’s credit markets are divided by the Brazilian central bank as follows: government-supported credit policies (code 7524); “free-market” credit for businesses (code 12128), and “free market” credit for consumers (code 12127).If one wants to see the combined series for “free-market” credit (businesses and consumers), the code is 12130. The first category, credit supported by government policies, includes loans through state agencies such as the National Bank for Economic and Social Development (Banco Nacional de Desenvolvimento Econômico e Social, BNDES for short), which offers subsidized or policy-oriented credit to sectors chosen by the government. The second category, “free-market” credit, includes all credit that is offered by banks to businesses and consumers. It should come as no surprise that the entire Brazilian credit market is subject to significant government control. Between 2004 and 2012, the average government share in total credit was 34 percent.For this calculation, the authors used the last month of each year (December) for government credit (code 7524) divided by total credit in the period (the sum of total government credit [code 7524] and “free-market” credit [code 12130]).
Figure 3 shows the growth of credit in the first two phases of the cycle. Displayed in the left panel of Figure 3 is the growth pattern of business credit. It is composed of government and free market credit for businesses. The average annual compound growth rate was 22 and 16 percent for Phases 1 and 2, respectively. Displayed in the right panel of Figure 3 is the growth pattern of credit for individuals. Note that the growth of credit to individuals is even higher than the growth of credit to businesses in Phase 1, reaching 27 percent. In Phase 2, there is an impressive 20 percent rate of continued growth in credit to individuals. Interestingly, the growth rates of credit in Phase 1 for both graphs (22 and 27 percent) are higher than their counterparts in Phase 2 (16 and 20 percent).
As alluded to in the previous section, certain factors unquestionably drove this credit expansion. In terms of alleged causes not specified by ABCT, one suggestion is that loose money policies in the major world economies directed large capital flows into Brazil. No matter how they are measured—net or gross—the inflows were unrivalled in the post-World War II history of Brazil (Hennings and Mesquita 2008, 107). Government fiscal and regulatory policy added more stimulation. One alleged example is an executive order authorizing banks to offer loans repayable through payroll deductions. This “innovation” significantly expanded credit (Coelho, Mello, and Funchal 2010).Again, the authors do not necessarily agree on all of these purported extra-ABCT causes. A planned follow-up study will explore this issue in greater detail.
Figure 3. Credit Expansion for Businesses and Individuals (in billions R$)
Source: Data from BCB (Brazilian Central Bank), elaborated by authors. Business credit series is a result of the sum of government credit policies for business (code 20021) with free market credit for business (code 12128). For individuals, it was calculated by the sum of government credit policies for individuals (code 20020) with free market credit for individuals (code 12127). It used December of each year as a basis for this calculation. For the calculation of compound average growth (CAG) in 2004, it used December 2003 as a starting point. Those series were discontinued and were only available until 2012, which means that the second phase will have a year less. A fall in interest rates would not be a problem per se, provided that it was driven by voluntary savings on the part of individuals (Hayek 1931). When individuals increase their savings, interest rates fall and funds flow to capital goods. When this route is followed, the time preferences of consumers can be synchronized with those of entrepreneurs who want to engage in new projects (Manish and Powell 2014). As a consequence, savings behavior during the recent Brazilian cycle must be analyzed to determine whether Brazil’s massive credit expansion was caused by a natural increase in voluntary savings or artificial state actions.
The next figure, Figure 4, juxtaposes the average growth rate of savings with the interest rate.For the 2004 savings-growth statistic, the authors used the 2003 statistic (15.3 percent of GDP) as the basis (World Bank 2018). In the first phase of the cycle (2004–08), the average annual growth of savings was 2.2 percent of GDP, rising from 15.3 percent (at the end of 2003) to 16.9 percent of GDP. However, the interest rate fell an average of 10.7 percent per annum. Its range was between 11.25 percent and 19.75 percent, with an average of 15.07 percent. In other words, the first phase was characterized by a large reduction in interest rates coupled with a relatively low growth rate in savings, as can be seen in the two bars on the left-hand side of Figure 4 below.
Figure 4. Average Annual Growth of Savings and Interest Rate
Source: World Bank and Brazilian Central Bank data, elaborated by authors. Interest Rate (SELIC) series: 4390. Table 5 below summarizes what happened to interest rates, savings, and monetary and credit expansion in Phase 1 and Phase 2. Phase 1 had a nominal average interest rate of 15.08 percent while Phase 2 had a nominal average rate of 9.77 percent, a fall of 35 percent. The average real interest rate for Phase 1 was 9.18 percent, while for Phase 2 it was 3.91 percent. In terms of savings, Phase 1 had an annual growth rate of 2.2 percent while Phase 2 had an annual growth rate of –0.3 percent.
Table 5. Interest Rates, Money, Credit, and Savings (Consolidated Results)
*Average for Phase 2 (Reset + M-Boom) It is reasonable to conclude that the consistent fall in the interest rate in both phases was not driven by an increase in voluntary savings. In fact, in the second phase, there was a decline in savings. The decline in the interest rate and increase in credit had a huge impact on credit expansion for businesses and individuals, which in turn caused a significant distortion in the structure of production as explained in the next section.
Central-Bank Control of the Interest Rate and Its Impact on Higher and Lower Orders of Production
To analyze the impact on the structure of production, we explored Phase 2 and 3 in greater depth. The structure of production was gradually changing in Phase 1 and started undergoing a complete distortion in Phase 2. As a result, the authors dedicated more analysis to this distortion that occurred in Phases 2 and 3.
The impact of lowering interest rates in the absence of voluntary savings will be different within higher and lower orders of production (Hayek 2008). In the terminology of statistical analysis, higher orders of production have a higher standard deviation in production levels than lower orders of production (Rothbard 2000, 9).
The results are consistent with ABCT. Recall that these results were elucidated earlier in the methodology section of this article for all sectors for which it was possible to obtain industrial-production data: Mineral, Intermediaries, Semi- and Non-durables, etc. Table 6 below displays the standard deviations of these sectors through Phase 2 and Phase 3. Standard deviations and the averages for each sector were then calculated.
Table 6. Industrial-Production Volatility for Phase 2 (Reset and M-Boom) and Phase 3 (Bust)
- All sectors included. To calculate the average standard deviation, two extreme values were eliminated from the data set (Minerals and Capital Goods). The average standard deviation of all sectors is 10.65. Figure 5 below reveals that three sectors of the economy were above average: Construction, Durables, and Capital Goods. These three sectors were clearly the most volatile and received the most impact from central-bank stimuli. They represent 75 percent of the higher-order sectors.
The data for the Construction series became available in January 2012—in the middle of the M-boom—which means that the actual standard deviation could be much greater than the recorded values indicate. This of course would have represented even stronger confirmation of ABCT.
Figure 5. Standard Deviation of Industrial Production Among Sectors for Phases 2 and 3 (Sep. 2008 to Dec. 2016)
Source: Central Bank of Brazil (BCB). One notable exception in the data was the mineral sector, clearly an industry belonging to the higher-order category. In Brazil, this industry has a large portion of its production in two main sub-sectors: iron ore and petroleum and natural gas (and its byproducts). For the iron-ore subsector, it is very well known that one of the most important markets is exports, and for that reason it is very sensitive to international-market conditions. In 2014, about 86 percent of Brazil’s iron-ore production was exported. In 2016, Vale (one of the largest iron-ore producers in the world) achieved a new production record which stood in stark contrast to the contraction witnessed in the other higher-order sectors (Construction, Durables, and Capital Goods) during the recession (Rosas and Machado 2017). Hence, iron ore is not synchronized with the internal Brazilian business cycle and thus of little relevance to this study.
As for petroleum and natural gas, the main supplier of those products is the state-controlled company Petrobras, one of the largest oil companies in the world. This sector is subject to heavy government intervention, thus central planning, not free markets, guides much of its decision making. During the boom, the government prevented the company from raising prices in an attempt to control inflation, even at the cost of significant losses (“Petrobras Approves New Fuel Price Readjustment Policy,” 2013). Such strong state influence muddles the analysis, since the government could accumulate large losses without compromising production.
Taking the long view, the standard deviation, from January 2004 to December 2016, is 10.64. In other words, the standard deviation converges to the average of other sectors. This is not the case for the capital-goods sector which over the same time span had a standard deviation of 18.27: almost identical to the present results. The fact that the petroleum and natural-gas sector is so extensively state controlled makes it almost certain that production decisions were influenced by political considerations rather than sound market fundamentals. This undoubtedly led to distortions in output.
In sum, the results show that Brazil’s higher-order sectors experienced the highest growth in the M-boom and the steepest fall in the bust phase compared to lower-order sectors of production. These results are consistent with ABCT. The Mineral sector is an anomaly because of its atypical export dependence in iron ore. The Petroleum and Natural Gas sector is another outlier because extensive government controls guide its production decisions.
Capital and Consumer Goods: A Closer Look
In Phase 1, industrial production for capital and consumer goods was relatively low in 2003, with index values of 50 and 68 (base year 2012 = 100), respectively. Figure 6 below reveals that both had tremendous growth in subsequent years until this growth was interrupted by the peak of the U.S. financial crisis in September 2008. After this interruption, growth fell precipitously until about the end of the first quarter of 2009. From January 2003 (50.9) to October 2008 (124.8) to February 2009 (73.4), capital goods rose 145 percent to a high and fell 41 percent to a low. From February 2003 (68.1) to October 2008 (110.3) to February 2009 (77.3), consumer goods rose 62 percent to a high and fell 30 percent to a low.
Figure 6. Industrial Production of Capital and Consumer Goods Indices (Base Year 2012 = 100)
Source: Central Bank of Brazil (BCB). Capital-goods series 21863. Consumer goods series 21865. After the Reset, the government began to suppress interest rates with the aim of stimulating the economy, going so far as to even threaten private banks to get on board the program (“On TV, Dilma Raises Tone to Private Banks and Asks Interest Cut,” 2012). The effects of this in terms of greater relative capital-goods volatility can be seen very clearly in Figure 7 below, which shows industrial-production index differences (capital goods minus consumer goods). Where the blue bars in the aforementioned figure indicate negative values, the capital-goods index was less than the consumer-goods index (see scale values on the right vertical axis of Figure 7). The inverse is also true.
Note that in Phase 1 (2004–08), capital-goods production exceeded consumer-goods production for only ten months of the 60-month Phase-1 period. In contrast, during the 2009–13 period (Phase 2), capital-goods production was higher than consumer-goods production for 44 out of 60 months, i.e., for nearly 70 percent of the phase. That fact supports the idea that the structure of production was distorting in Phase 1, however, only in Phase 2 did this distortion reach the point of irreversibility. This is consistent with ABCT, where production of capital goods grows faster than that of consumer goods in the boom phase with this production only to be eventually corrected by market forces during a subsequent bust.
The interest rate is also displayed in the graph, showing a trajectory of successive declines and then a sustained low rate through the T-boom and M-boom (see scale values on the left vertical axis of Figure 7 below).
Figure 7. Interest-Rate Impact on the Structure of Production
Source: Central Bank of Brazil (BCB). SELIC series 4390. VI. PHASE 3: RECESSION In the second quarter of 2014, Brazil’s output began to fall. The next graph shows year-on-year growth in Brazilian GDP on a quarterly basis. GDP shrank for 11 consecutive quarters, resulting in the longest recession in a century.
Figure 8. Quarterly GDP Growth During the M-Boom and Bust Periods 2009-16
Source: Brazilian Institute of Geography and Statistics (IBGE). Quarterly GDP growth series 5932. Credit had a delayed impact on Phase 3 (bust) of the business cycle. Figure 9 shows the long expansion of credit as a percentage of GDP for both businesses and individuals. For 2012, credit grew at a 5.7 percent rate for businesses and a 6 percent rate for individuals. By 2015, the rates had fallen to 2.4 percent for businesses and 3.1 percent for individuals; both forms greatly slowing with business credit falling faster. The following year, 2016, credit expansion entered a clear tailspin, growing at a rate of –13.4 percent for businesses and –1.2 percent for individuals.
Figure 9. Credit Expansion and Contraction as a Proportion of GDP (%)
Source: Central Bank of Brazil (BCB). Business credit/GDP series 20623. Individual credit/GDP series 20624. As can be seen in Figure 9 above, there was no observable contraction in credit at the beginning of the bust. Instead, credit levels fell only in the third year (2016), with businesses cutting back (–13.4 percent) much more than individuals (–1.2 percent) as confirmed in Table 7 below.
Table 7. Business and Individual Credit as a Percentage of GDP (M-Boom to Bust)
Source: Central Bank of Brazil. Business credit/GDP series: 20623. Individual credit/GDP series: 20624. Recession is the healthy part of the recovery process because it is the adjustment of the economy back to its original condition (Rothbard, 2009). Without further state interference, the economy will move back to equilibrium, prices and wages will fall, and unviable businesses will go bankrupt. The recession is the economy’s attempt to adjust to the state of current natural time preferences, utility, and scarcity, which is not necessarily the pre-boom state of affairs because of at least slight changes that could have occurred in these underlying phenomena. This can be observed in the production of capital and consumer goods in Figure 10 below (base year 2012 = 100). Production of capital goods falls steadily between 2014 and 2016, a decline greater than that experienced by consumer goods.
Figure 10. Structure of Production of Capital and Consumer Goods Indices for Phases 2 and 3 (Base Year 2012 = 100)
Source: Central Bank of Brazil (BCB). Capital goods series 21863. Consumer goods series 21865. Despite the visible difference in the two series in the graph, the phenomenon of returning to “the old standards before the crisis” affected industrial production. The authors noted the six months with the highest average value in the boom and the lowest average value in the bust. They also compared the lowest average value during the recession with the six months before the Reset in which similar values could be found. Results will show how many years of performance the economy lost in the bust phase. The reason for searching before the Reset is the Brazilian government’s reaction to the peak of the U.S. financial crisis in September 2008 (which led to muddled data for 2009). The authors used six-month averages to insulate the results from monthly seasonal variations.
For the production of consumer goods, the highest performing six months in the M-boom was the second half of 2013, when the index averaged 106.56. The worst six-month period in the bust was the first half of 2016, with an average of 82.16. The economy then returned to the type of output levels it had in the first six months of 2005 when the index averaged 82.63. That is, consumer-goods production returned to the level of 11 years previous.
For capital goods, the highest level was in the second half of 2011, with the index averaging 115.31. The lowest average in the recession was 66.53, recorded in the first six months of 2016. Capital-goods production fell back to levels not witnessed since the first half of 2004. In other words, this was a decline lasting 12 years.
Table 8 below summarizes the performances of capital and consumer goods in terms of all averages combined among the M-boom and Bust stages.
Table 8. Recession Adjustment Process (Industrial Production)
*half = two consecutive quarters Table 8 shows that capital goods returned to their initial condition in the T-boom phase. This is consistent with ABCT’s prediction that the economy would return to approximate pre-boom levels (Mises 2008). Consumer goods declined to their level of 11 years previous (in the first half of 2005). Capital goods fell even more, falling to their level of 12 years previous (in the first half of 2004). The Brazilian economy returned to its approximate initial conditions when the boom first started in 2004.
VII. INFLATION THROUGHOUT THE BUSINESS CYCLE Brazil’s economic history is full of inflation inanity. Between 1964 and 1994, the nation’s accumulated inflation was more than one quadrillion percent when measured by the IGP–DI index (Leitão 2011, 23). The inflation tsunami was finally brought under control by the 1994 Real Plan, which implemented a new currency and several other important measures. Inflation in the year following the plan was approximately 13 percent. Although this is not a remarkable achievement per se, it is impressive when compared to 1993 when inflation averaged 30 percent per month.
The Central Bank of Brazil (BCB) has an inflation target that guides its interest-rate policy. If inflation is rising or expected to rise, interest rates will rise and the opposite occurs for falling inflation. In addition, BCB sets upper and lower limits of two percent (above and below its inflation goal), which means that inflation must be inside this pre-established range. BCB uses the Broad National Consumer Price Index (Índice Nacional de Preços ao Consumidor Amplo, IPCA for short) as its official measure to guide its interest-rate decisions (Central Bank of Brazil 2016b).
Figure 11. Consumer Inflation
Source: Central Bank of Brazil (BCB). IPCA series 13522. Inflation target series 13521. Figure 11 above shows the performance of consumer inflation during the three phases. The graph is very clear when it comes to BCB inflation-policy effectiveness. The periods in which inflation was mostly outside of BCB’s target range were mainly in the bust phase. However, as further analysis will show, inflation was postponed rather than tamed by BCB interventions.
According to Table 9 below, in 49 months of Phase 1, inflation was within BCB’s target range, a success rate of approximately 88 percent. Inflation averaged about 5.3 percent per annum during this period. Phase 2 had similar results, however, it was the period when government interest-rate interventions became aggressive. Although 82 percent of the months in Phase 2 displayed inflation within BCB’s target range, inflation was artificially suppressed by many state actions. ABCT predicts that consumer inflation will rise in a boom and fall in a bust. However, if government interventions prevent inflation from rising in a boom, it would be rational to expect that a subsequent bust will be hyper-affected by the inflationary forces that were artificially suppressed during the boom.
Sure enough, in the bust, Brazil’s inflation rate was higher than in any other phase. In January 2016, inflation reached a peak of 10.71 percent, the highest level in the previous 13 years. During the bust, inflation was within BCB’s target range for only five months out of 34, giving the central bank a rather unimpressive success rate of 15 percent.
Table 9. Inflation-Goal Performance
For the classification of inside or outside the target range, the inflation range set by BCB was used (Central Bank of Brazil 2018).
How Government Interventions Postponed Economic Recovery
As mentioned above, government interventions in Phase 2 postponed inflation that would have been ordinarily felt during a period of credit expansion. Therefore, higher rates of inflation were experienced only in Phase 3, and still only in a subdued manner.
Inflation as measured by IPCA has two main components: a) “free market” prices; b) government-controlled prices (“Petrobras Approves New Fuel Price Readjustment Policy” 2013). The first component covers all prices that are set by voluntary exchanges in the “free market,” while the latter category covers prices set by government decree via its agencies, companies, and structures. Government-controlled prices are also set at the federal, state, and municipal levels. In May 2016, government-controlled prices represented nearly a quarter of the IPCA (Central Bank of Brazil 2016a) and that proportion is similar to the one that prevailed in earlier years (Solomao 2013). In Brazil, the government uses its discretionary authority to influence prices as measured by IPCA. If the government postpones price increases, the index will be held down artificially.
In Phase 2, government interventions intensified. Table 10 below summarizes many of those decisions which worked to postpone inflation (which should have been felt during the M-boom but was not felt until the bust).
Table 10. Brazilian Government Interventions to Suppress the Inflation Index (Selected Indices)
All the interventions in Phase 2 deferred inflation to the future. The effects were felt only after the M-boom, when most of the artificially low prices could not be sustained. In 2013, there was a 15.65-percent fall in residential electric-power prices as a result of government intervention. However, in 2014 and 2015, prices rose 17.06 percent and 50.99 percent, respectively.Accumulated inflation for each year. Data from BCB series 4453.
The following graph, Figure 12, juxtaposes year-by-year IPCA controlled prices with IPCA free-market prices. The graph shows government-controlled prices sliding way below free-market prices in both boom phases (but especially in the M-boom years of 2011–13) before disproportionately racing ahead of them in the bust years of 2014–15, reaching a peak of 18.07 percent in 2015. At a minimum, the striking divergence between the two series between 2011 and 2015 evokes questions about its cause.
Figure 12. Controlled Prices Compared to Free-Market Prices (Annual Averages)
Source: Central Bank of Brazil (BCB). IPCA series 4449. IPCA free-market series 11428. Controlled prices fell from an annual rate of 5.68 percent in Phase 1 to 3.85 percent in Phase 2, a fall of 32 percent. During the same period, free market prices rose from 5.24 percent to 6.34 percent, a rise of 21 percent. Controlled prices then rose by an annual average of 9.63 percent in Phase 3, a 150.1-percent increase when compared to Phase 2. Free market prices also rose in Phase 3, but the average increase was about 14.4 percent when compared to Phase 2 (see Table 11 below).
Table 11. Annual Inflation: Controlled vs. Free-Market Prices
Without question, Brazil’s government made its recession worse through its manipulation of prices. Instead of leaving prices to fluctuate normally in response to market forces, the government used its power to influence prices as part of its interventionist agenda. Price adjustment, though, cannot be postponed forever. The result was that when the recession finally arrived in 2014, inflation was not able to fall as part of the natural adjustment process. Because of past government interference, prices first had to perversely spike in 2014–15 (the Bust) to compensate for past suppression.
The bust is the start of the recovery process (Rothbard 2009) when prices fall, malinvestments are liquidated, bankruptcies rise, and the high debt ratio for households and companies remains steady or falls (Salerno 2012). However, one main component of the recovery process—prices—was not aligned with the business cycle. Prices had to rise because of government suppression during the boom phases, and this had to occur in the recession. The bust’s increase in inflation combined with negative industrial production was a deadly combination in hindering business profitability.
If the government had not held down prices in the boom it would be realistic to expect that inflation would have fallen in the early months of the bust (2014), and as a consequence, the recovery process would have been faster. Instead, inflation only began falling about two years after the recession began.
VIII. EXPECTED RESULTS AND OBSERVED FACTS The observed facts from the recent Brazilian experience, when compared with ABCT expectations, are not surprising. Table 12 below reveals that 13 out of 15 (87 percent) expected results from ABCT theory were confirmed by the data.
The variables that fell outside expectations were three: savings, inflation, and money supply. Savings actually rose 7.4 percent in the first year of the bust (2014). However, in 2015 it fell 11.3 percent, turning the net effect negative. Individuals did not increase savings in the period. However, for consumption the fall was far greater. As a standalone variable, savings declined but when compared to consumption, it experienced a lower decline.
As for inflation, as discussed in the previous section, Brazil did not experience a sharp fall during the bust. Government intervention prevented controlled prices from rising during the boom, which meant that they had to adjust upwards in the bust. Thus, controlled prices climbed 18 percent in 2015. If the government had not manipulated prices, then prices almost certainly would have fallen in the bust period.
As for the money supply (M2), as Table 4 above indicates, while the average growth rate in M2 was certainly not negative, it was about 35 percent of what it was during the T-boom. M1 was about 29 percent of what it was during the T-boom. The growth rate of both measures of the money supply had declined significantly.
Table 12. ABCT Realized Results
*See CAG for M2 in Table 4 above. While the growth rate of M2 was not negative it was on average a little more than a third of what it was during the T-Boom. IX. CONCLUSIONS This study intended to analyze the 2004–16 Brazilian business cycle through the lens of Austrian Business Cycle Theory (ABCT). From ABCT, 16 expected results were delineated and nearly all of them were empirically confirmed, thus strong supporting evidence in the recent Brazilian experience was found for ABCT. The boom initiated in 2004, the structure of production began to be distorted, and this distortion became more pronounced during the second part of this boom. The Brazilian government continually lowered the interest rate, bringing it low enough to create an artificial boom followed by a severe bust that was not just another typical “flight of the chicken,” but Brazil’s most severe recession in more than a century.
This study’s findings reinforce ABCT’s accuracy in explaining business cycles. In this day and age, it is surprising that mainstream economists still ignore or misinterpret ABCT (Garrison 1999, Evans 2010, Salerno 2012). As for politicians and regulators, there is no way that governments can precisely manage a modern economy through monetary and interest-rate central planning, and it is certainly not possible to do so without temporarily warping an economy’s production structure.
This article aspires to be one of the first scientific studies of the recent macroeconomic crisis in Brazil to utilize the theoretical framework of ABCT. The hope is that it will introduce a fresh perspective in economics for Brazilian economists, business executives, entrepreneurs, academics, and political leaders who can effect social change in Brazil. In a recent survey (Heritage Foundation 2018), Brazil ranked 153 out of 180 nations in terms of having one of the lowest levels of economic freedom in the world. The authors hope that this study will help reverse Brazil’s dismal ranking in economic liberty and bring about lasting changes in Brazil for the economic betterment of its 210 million people.
The Origin of the Prolonged Economic Stagnation in Contemporary Japan: The Factitious Deflation and Meltdown of the Japanese Firm as an Entityby Masayuki OtakiOxfordshire, UK: Routledge, 2016x + 136 pp.
Abstract: While Otaki has seen what the Japanese economic disease is, he has failed to understand what fundamentally causes it. Somehow, Otaki attributes the Japanese troubles to a failure to follow the teachings of John Maynard Keynes. A Japanese economy on the gold standard would be insulated from the endless boom-and-bust cycle of the Keynesian shell game. There would have been no bubble, no collapse, and no lost decades. But Otaki does not see this, and clings to a sincere belief that Keynesianism is the cure for what ails Japan.
monetary policy gold standard keynes business cycle japan Economics writing has a reputation for stolidity unto soporiferousness. To be fair, prose that trades in margins, utils, and curves-named-after-other-economists is perhaps a bit difficult to jazz up enough to read like For Whom the Bell Tolls. If one asked the average undergrad to rate his or her econ textbook on spiciness, the response might clock in somewhere between “cell phone contract” and “house dust.”
That may be true, but let no one—and I mean no one—lay the blame for it at the feet of Masayuki Otaki. The Origin of the Prolonged Economic Stagnation in Contemporary Japan: The Factitious Deflation and Meltdown of the Japanese Firm as an Entity (whew!) is, hands down, the most raucous economics volume I have ever read. This is gripping, dramatic stuff, larded with high-flown moralizing about policy and theory that is sure to grab and hold the attention of even the most indifferent reader. In the Preface alone, a mere two pages, Otaki manages to deploy “grievous,” “precarious,” “vicious,” “spurious,” and even “egregious,” a running of the “-ous” adjectives that is perhaps even more thrilling than the running of the Pamplona bulls. I was hooked. Otaki had me at “acute roundabout trespass”; I swooned at “substantively surcharged nominally on account of keeping the Japanese border from the menus of China”; I went all doe-eyed at “fanatic captives in the quantity theory of money”. Who could put this book down? Not I. I read it in one sitting, straight through, anxiously, even rambunctiously, turning pages to find out what would happen next.
So, what happened? Well, to be honest, I’m not exactly sure. Otaki has a gift for making economics read like dispatches from the French and Indian War, but I confess I was a little too thick-headed to penetrate the meaning of some of the more esoteric passages (and there are many). Here are the main points, as near as I can tell. (Otaki very helpfully includes a “concluding remarks” section at the end of each of his seven chapters. Without those, I would have been quite lost.)
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Otaki does not like Japanese prime minister Abe Shinzō or, more specifically, his economic policies, which critics and supporters alike refer to as “Abenomics.”
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One of the main reasons Otaki does not like Abenomics is that he sees it as an extension of “Koizuminomics” (a term that I just made up and which I do not expect to catch on, for obvious reasons). Koizumi Jun’ichirō was the prime minister of Japan from 2001 to 2006, and made it the centerpiece of his administration, at least in the early days, to privatize the financial arm of the Japanese postal service. Unlike the United States, where the post office is responsible mainly for delivering grocery store circulars while racking up billions of dollars in taxpayer-funded deficits and campaigning on the side for Democrats, the Japanese postal service is generally efficient and well-managed. So efficient and well-managed, in fact, that it also has its own bank. (US post offices provided this service, too, until about fifty years ago.) The postal bank remains in a state of semi-privatization almost two decades after Koizumi’s initial attempts at reforms, but it still holds the equivalent of some three trillion dollars US in savings and insurance assets. Otaki argues that the Koizumi brand of “privatization” was really a kind of crony capitalism that Otaki calls “pseudo laissez faire.”
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The Japanese people overall have been sold a bill of goods by the late-postwar pseudo laissez fairers. While early-postwar Japan still took seriously the firm as an entity that allowed for transactions not possible in the broader market (Otaki relies heavily here on Coase and Williamson, and also on the alternative firm theory of Uzawa Hirofumi and Edith Penrose), the advent of neo-liberalism and globalism, and in particular Japanese foreign direct investment (FDI) in other Asian countries, have combined to drive down wages for the average Japanese worker and hollow out the firm. Also, in the past, many Japanese companies held shares of one another’s stock, which encouraged at least a modicum of regard for the wider social costs of corporate actions, but today the neo-liberal shareholder has taken the place of the worker and the firm as the beneficiary of corporate profits.
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The Japanese stock market (as well as the American stock market) has boomed following the Lehman shock of 2008 because of foreign investors, and has nothing to do with Abenomics except negatively, because investors are looking for something more profitable than the zero or even negative interest rates currently on offer by Japanese banks.
This is the basic scope and outline of the book. There are thus, according to Otaki, major structural problems with the Japanese economy. This much is clear, and even those who have not quite broken the code of Otaki’s highly idiomatic English should have no trouble grasping that he is against crony capitalism (he calls the politically-connected president of Japan Railways Tokai “a pharaoh who decided to build his pyramid”), finds Prime Minister Abe and his “right-wing” ideas “appalling,” and urges an “evacuation from the myopic policy decisions” such as zero-interest rates and the spending debacle of the Tokyo 2020 Olympics.
One is inclined to agree with much of Otaki’s diagnosis. Surely, the Japanese economy is in bad shape, and surely it should be obvious to everyone but government bankers by this point that more “stimulus” spending has as much chance of “reincarnat[ing]” (to use Otaki’s term) the Japanese economy as a savings account at a Japanese bank has of generating interest. Otaki is right about all that, and I would argue that he is also right (I tend to agree with Uzawa) that one of the secrets to Japanese economic success was its very strong communal culture, which has been largely undermined in an age of crony-capitalist “rigging” (again, Otaki) of the labor market and the economy overall. There are things that firms in Japan have tended to do that have helped to humanize global competition and shield average workers from much of the destruction side of creative destruction. As the firm has changed and as Japanese business practices have been caught up in a political economy faced with major social and geopolitical upheavals, the old ways have faltered and younger workers have noticed that things just aren’t what they used to be. Stimulus doesn’t stimulate because the patient is, for all intents and purposes, already dead. Otaki is largely on the mark in this general assessment.
But here is also precisely where Otaki’s analysis breaks down. For, while he has very nicely seen what the disease is, he has failed, in my view, to understand what fundamentally causes it. In fact, I think he may be very much misinformed. For, while Otaki sees the out-of-control government spending and jerry-rigged “disinflation” and “deflation” as creatures of the “fanatic advocates of the exorbitant expansionary monetary policy [who] are only naïve captives of the quantity theory of money that has been apparently rebutted by the recent experience both in Japan and the United States,” he somehow, in a way that I just cannot figure out, at the same time manages to attribute all of this to a failure to follow the teachings of John Maynard Keynes. “Those who have common sense can hardly deny that the exorbitant expansionary policy fails in recovering the economy,” Otaki swashbuckles in the closing chapter, the excellently titled “We still have time and power.” Bravo! But wait. What’s this? Otaki also seems to think that Keynes, of all people, supplies the antidote to this recklessness. Somehow this all begins to sound like the Atkins Diet.
Alas, Otaki’s devotion to Keynes is apparently real. There’s this passage, for example:
[…] the prominent disinflation in [the] Japanese economy is not a monetary phenomenon caused by the shortage of the quantity of money, but a real phenomenon which comes from the stagnation of the labor productivity progress.
Well, OK, labor and productivity are certainly very important. But the problem arises when Otaki next introduces a kind of ingrown Keynesianism to explain how “price stability” is the answer to stagnation in labor productivity. “In this sense,” Otaki continues,
the concurrent monetary policy by the BOJ [Bank of Japan], which unreasonably aims to promote inflation via perturbing the confidence of money, is quite precarious. Keynes [citing Keynes (2013)] asserts that “[a] policy of price stability is the very opposite of a policy of permanently cheap money.” One of his reasons is that “[m]odern individualistic society, organized on lines of capitalistic industry, cannot support a violently fluctuating standard of value, whether the movement is upwards or downwards. Its arrangements presume and absolutely require a reasonably stable standard.”
Keynes is half right. There must be a “reasonably stable standard” if an economy is not to fly off the rails and spiral out of control, as the Japanese economy did when it overheated at the end of the 1980s and then imploded just as Debbie Gibson was going out of style. The reason that Japan has not found its feet again is precisely because of the failure to find this “reasonably stable standard,” coupled with the handicap of not having the advantage that the American economy has (and which Otaki also mentions) of being able to print the world’s common currency.
But how can Otaki fail to see that the very problems he diagnoses in the Japanese economy are inherent in Keynesianism? For example, this “vicious cycle” which Otaki laments just three pages after citing Keynes could also be read as Keynesianism’s calling card:
The Busted Bubble and the Surge of FDI -> Stagnant Domestic Markets -> [Rising] Unemployment -> [Decreased] Labor Productivity -> Disinflation -> [Reduced] Consumption -> Stagnant Domestic Markets
“We consider that the current Japanese economy is entrapped by the vicious cycle,” Otaki concludes. I concur. But this vicious cycle is the creature of Keynesianism, not something alien to Keynes’s ideas.
An economy must have a “reasonably stable standard” because, as Mises proved in great detail in Human Action, people act for a myriad of reasons and there is really no way to index and organize the totality of their interactions—an economy—without a standard that is infinitely fungible and common to all. The problem with fiat money, such as that printed by the ream by the Bank of Japan, the Federal Reserve, and other Houses of Keynes around the world, is that it is not money at all, but so many admission tickets to a political con game.
So, of course the Japanese government is rigging the Japanese economy. What did Otaki expect? The Roman emperors debased their own currency (also covered at length in Human Action), and virtually every other sovereign, prime minister, president, and chief of the exchequer who could get away with it has done the same. If someone is OK with being a member of an organization which commits armed robbery from hundreds of millions of bank accounts once every April 15th, then he or she is probably also OK with purloining money in other ways, for example by setting up a monopoly on Gresham’s Law and turning all of a given polity’s money into political scrip. It’s quite a racket. It’s what central banks do. Otaki seems to think that the Bank of Japan will one day wake up and start acting morally and for the good of the country—perhaps in the same way that a python might one day start atoning for his past life by volunteering at the Small Mammals Nursing Home. This chicanery is the essence of Keynesianism, and there is no way to prescribe the doctrine without also administering the “fatal conceit” that goes along with it.
Fortunately, there is a “reasonably stable standard” which has long proven capable of thwarting the designs of evil men “enamored with the supposed beauty of his own ideal plan of government”: gold. Gold is real money. Gold works as money precisely because nobody can make gold but God. (The reason Isaac Newton spent so much time on alchemy experiments was not because he was kooky, but because as the Master of the Royal Mint he spent decades fighting counterfeiters and wanted to be sure that they could not reproduce the coin of the realm.) Government bankers, who have never been known to scruple about any possible differences between themselves and the Deity, elide this one sticking point and end up running a nationwide—even, in the case of the Fed, a worldwide—counterfeiting scheme of their very own, to enormous profits for themselves. But with gold, this is not possible. Governments and their bankers are kept on a gilded leash. The bad that a state would do—and, boy, would it do it if it could—is caged up by an eternally sound currency. Keynesianism is the Houdini act that lets governments wriggle out of this pen and do whatever they please with the people’s cash.
But Otaki is having none of this. He wants Keynesianism both ways. For example, he compares the collapse of the Japanese bubble economy in the early 90s and the subsequent lost decades to the Showa Depression, when the Great Depression in the United States began to affect the Japanese economy in the early 1930s. Otaki attributes the worsening of the Showa Depression to the return to the gold standard, something that Otaki says was “genetically infeasible for Japan judging from the incessant current account deficits adjacent to huge fiscal deficits.” Investors saw the return to gold coming and cashed out, thus triggering an avalanche of defaults and business closings.
[…] the rejoining at the excessively high parity only triggered the tremendous outflow of the fiducial currency. Every subtle speculator foresaw the embargo in the near future (December 1931) at the very beginning of return to gold standard. They purchased huge amounts of USD in exchange for fiducial currency, and thus severe domestic monetary contraction occurred.
To summarize, the most prominent feature of the Showa Depression is the appalling domestic monetary contraction owing to the unreasonable return to gold standard. Such contraction choked bank loans especially towards small and fragile firms in the fabric industry. [Japan’s economy had relied especially heavily on silk production in the early days of Meiji industrialization.] Facing the hardship, these entrepreneurs were forced to sell their products at damping prices, cut wages and fire some parts of their employees. Consequently, prominent deflation progressed.
Otaki sees the return to the gold standard as the problem, then. Like Keynes quoted above, Otaki is half right. Yes, returning to the gold standard can wreak havoc on an economy, but only in the way that restoring law and order occasionally wreaked havoc in Tombstone. Wyatt Earp had to crack a few heads to get folks to settle down. When “subtle investors” saw the sheriff on the horizon, they stuffed their carpetbags full of the locals’ flatware and hightailed it out of town. But this is hardly the sheriff’s fault.
Amazingly, in the very next paragraph after the one quoted above, Otaki blames the “current prolonged stagnation” in Japan on “easy monetary policy.” Otaki wants to contrast this with the Showa Depression, but on closer analysis it is obvious that the two things are the same. Keynesianism is the hocus pocus that seeks to cover over naked theft with highfalutin words. It is hard to see how Otaki can reconcile his support for Keynes with statements such as this:
The stimulations to the economy, which only involve the maintenance of the current spurious prosperity, are immoral, because such policies and projects gravely disturb the income distribution of the future generations via the debt-management policy. The imprudence in the fiscal policy and the huge scale project of the private sector stems [sic] not only from moral hazard in the limited liability but also from the illusion based on the rootless expansionism [emphasis in original] that is a negative inheritance of the High Growth Era.
Otaki seeks to accomplish this with an appeal to Burke, and to measured reform overall. But as Otaki’s own telling of just recent Japanese history makes clear (and as a wider survey of Japanese history, or of any other country’s history, will confirm), it is not reform that is the problem, but the so-called reformers. The weakness of any economy boils down essentially to just this: some people will try to hijack it via its money system and turn the entire thing to their own ends. There is no way to prevent this with laws and policies. There must be a sound currency, impregnable to human folly. That currency is gold.
A Japanese economy on the gold standard would be insulated from the endless boom-and-bust cycle of the Keynesian shell game. There would have been no bubble, no collapse, and no lost decades. Japanese firms would be healthy and diversified, and there would be no tax-guzzling boondoggles like World’s Fairs and Olympic Games to dazzle the very populace which has been railroaded by the captains of crony capitalism, who always grow rich while the economy and everyone else within it grow poor.
The Origin of the Prolonged Economic Stagnation in Japan is a very good overview of one theory of why the Japanese economy has been in the doldrums for so long. Masayuki Otaki is certainly sincere in his belief that Keynesianism is the cure for what ails Japan. But he is also wrong. I recommend this book as a very helpful primer on some of the more esoteric aspects of Japanese economics, and also as a foil for figuring out what Keynesianism is, and why it offers no future for any economy besides more of the same.
Abstract: I show evidence of Austrian boom-bust dynamics in historical data on the production structure of 28 developed economies. I employ an autoregressive distributed lag model to find that policy-induced deviations from the natural rate of interest increases roundaboutness. This could instigate an unsustainable boom. Additionally, I find that early-stage industries have higher cyclical sensitivity than late-stage industries, consistent with Austrian time-value dynamics in the structure of production.
Hayekian triangle roundaboutness monetary policy central bank business cycles JEL Classification: B53, C33, E23, E32, E43, E50 This paper is based on my MSc thesis. For valuable comments on earlier drafts of this paper including the thesis I thank Prof. Dirk J. Bezemer, Dr. Mark Skousen, Prof. Roger W. Garrison, and Prof. Lex H. Hoogduin. Last, I thank the editor and an anonymous referee for helpful suggestions that considerably improved this paper. All errors remain my own.
Mark Gertsen (markgertsen@gmail.com) is on the faculty of economics and business at the University of Groningen.
INTRODUCTION The influence of interest rates on the production structure of the economy is a key concept within the Austrian framework. In particular, interest-rate-setting central banks are deemed to be institutions distorting the market, often with a combination of artificially low interest rates and expansionary monetary policy. During the Great Moderation some economists claimed that the central banking puzzle was solved, but the 2008–09 global financial crises reignited the debate around this topic. A decade later, central banks are still dealing with the legacy of this crisis, for which the consequences are yet unclear. In this paper I provide an uncommon (to most policy-makers) though sensible view that could enrich the debate about the consequences of policy-induced monetary expansion inevitably followed by boom-bust episodes similar to the one in 2008–09. To substantiate, I attempt to quantify the difference between the natural rate of interest, defined by Wicksell ([1898] 1962) as the unobserved equilibrium price of savings and investments, and the market interest rate set by the central bank. Subsequently, I explore the effect of this interest rate gap on the production structure, or roundaboutness, of 28 OECD economies over the years 2000–14. Roundaboutness as originally pioneered by Menger (1871) and later expanded by Böhm-Bawerk (1891) explains the indirectness and lengthiness of the process in which consumption goods are created. To capture the roundaboutness of an economy, I make use of the Gross Output (GO) metric pioneered by Skousen (1990, 2015, 2018). GO measures the combined value of all stages of production in the economy.While Skousen has formalized and widely promoted the concept of GO, it is wholly based on Rothbard’s (2009, 396–403) distinction between the Keynesian “net expenditure / income approach” and the Austrian “gross expenditure / income approach”. By dividing GO by GDP, one obtains a measure which increases (decreases) with a lengthening (shortening) of the production process. Böhm-Bawerk (1891) argues that more indirect processes ceteris paribus are associated with more economic progress and increased productivity. However, expansionary monetary policy is prone to instigate an unsustainable growth path. A low-interest rate policy stimulates investments which are not profitable under the natural rate, leading to malinvestment and overconsumption, in turn leading to boom-bust dynamics (Mises [1912] 1953; Hayek 1932, 1933; Garrison 2002, 2004).
This paper contributes in three ways. First, I construct a unique data set on Gross Output for 28 OECD countries over the years 2000–14. Second, I develop a proxy measure for interest rate gaps combining the Taylor rate, the consumption-investment (CI) rate and the long-term interest (LTI) rate. Austrian theory suggests that a larger interest rate gap positively influences the roundaboutness of the economy.
Third, I explore this theoretical relation in autoregressive distributed lag (ARDL) models. There are a few studies which examine this relation for individual countries (e.g. Mulligan 2006; Carilli et al. 2008), but the present paper is the first to explore the average relation for a large number of developed economies.
The result are consistent with Austrian business cycle theory (ABCT). I find that larger interest rate gaps are indeed associated with greater roundaboutness of the economy. Additionally, I find that this effect is stronger in a subsample of the five most roundabout of 65 industries than on average (though only to prolonged gaps, of more than one year, and when using a Taylor-based proxy for the interest rate gap). In comparison, the association is three to five times weaker in a subsample of the five least roundabout industries. Also, these additional analyses are in line with Austrian business cycle theory, which implies that more roundabout, hence more capital intensive industries, should respond more to interest rate changes (Skousen, 2015, 273–304). An important qualifier of this analysis is that the results are based on average effects found in historical data—they are not forecasts, nor descriptions of individual countries. The findings do suggest that on average in 28 OECD countries during the years 2000–14, the association of empirical proxies for the interest rate gap and roundaboutness were just as suggested in Austrian business cycle theory.
Apart from the scientific contribution, the study has clear societal relevance. The effects of expansionary monetary policy are obviously of great and very topical concern. Monetary mismanagement is fundamental to macroeconomic dysfunctions in the intertemporal allocation of resources (Dobrescu et al. 2012). Policy makers as well as academics will benefit from an analysis that adds the Austrian perspective to what is primarily a mainstream debate on the direction of monetary policy.
This paper is further organized as follows. Section 2 provides a survey on the current knowledge about ABCT, both theoretical and empirical. Special attention is given to the theory and application of the Hayekian triangle. In section 3, I present an econometric model to estimate the responsiveness of (sectoral) roundaboutness to the interest rate gap and in section 4 I explain how the dataset is constructed. Section 5 provides results including model variations and a sensitivity analysis. Section 6 concludes the paper and offers some suggestions for future research.
- AUSTRIAN BUSINESS CYCLE THEORY TO DATE 1.1 Roundaboutness and Capital Theory
The conventional measure for the size of the economy is the gross domestic product (GDP). Skousen (2010, 2015, 178–85) lists the shortcomings. GDP is a net output measure of finished goods and services, which leaves out intermediate production activity and business spending in the supply chain. Each of these expenditures is the result of entrepreneurial decision making, which in turn influences the rest of the economy. Entrepreneurs do not start or expand activities based only on value added. If we are to construct an empirical proxy for ‘how the economy is doing,’ it should capture the totality of spending decisions. A gross measure, not a net measure, satisfies this criterion. Note that because of this theoretical motivation, there is no double counting problem, a common objection to the GO concept. In a system of accounts, intermediate business to business transactions are just as relevant and real as economic activity linked to final goods and services (Jorgenson et al. 2006). As Skousen (2015) puts it, “GO is the top line and GDP is the bottom line of national accounting, ….. [and both] are of equal importance” (p. xix). I will operationalize this below by using both GO and GDP in an empirical proxy of roundaboutness.
The degree of roundaboutness in an economy, a concept of central theoretical importance in Austrian theory, can be proxied by the value of GO relative to GDP. With increasing roundaboutness, increasing amounts of savings-induced capital are employed to sustainably increase the capital intensity and efficiency of the intertemporal production process. The aggregate of all these processes, with varying degrees of efficiency, forms the time structure of production of the economy. Hayek (1932) further developed the time structure of production into a schematic triangular construct, known as the Hayekian triangle. The improved version of this triangle as designed by Garrison (2002) is nowadays used to describe the successive processes of capital (goods) accruing value from the original means of production, through the resource phase, up to the final stage where they are transformed into consumption goods. Capital is heterogeneous: it moves up along the hypotenuse as working capital, which, at the final stage, is consumed (in)directly or put into use as fixed capital, aiding future working capital forward in the production process.
The concept of time is of crucial importance to capital heterogeneity and its impact on economic booms and busts. Garrison (1990) shows that the neoclassical stock-flow approach, which claims production and consumption are simultaneous, is unrealistic. The theory assumes all subjective factors in the production process as fixed through time and view the capital stock as a ‘permanent fund.’ This process may appear simultaneous, but when one refrains from the temptation to generalize capital as an attempt to formalize it, one notes that a fundamentally uncertain future by definition means the production process is subjective and not fixed through time. The subjective factors in this process are typically entrepreneurs who make decisions about how and what capital formation takes place (Mises [1949] 1998). These decisions are based on the interpretation of the economic outlook and are by no means based on clairvoyant expectations. Inherently, a fraction of the entrepreneurs always either misjudges the economic climate or is downright unfortunate, and the macroeconomic impact of these events is relatively small. However, when there is a broad central-bank-induced misconception about future demand due to misaligned—investor vs. consumer—(time) preferences, the fraction of bad decision-making significantly increases, which causes a consumption boom and a severe capital misallocation at the same time. Were it for neoclassicals, capital could easily be moved elsewhere at no cost. In reality, however, the liquidation, the adjustment and the redirection of wrongly allocated capital is a painful process.
1.2 Interest Rate Effects and Financial Sector Dominance
The main culprit for capital misallocation is the distortive effect of monetary expansion on the natural rate of interest. An excessive increase of the money supply sends conflicting signals to investors and consumers creating a wedge between the savings and investment equilibrium on the loanable funds market. The expansion lowers the interest rate and creates two virtual equilibria: (1) consumers see the lower rate as an incentive to spend more now, while (2) investors are led to believe that consumers will spend more later. This illusion of a surplus of available savings for early-stage investment purposes has been called ‘forced savings’ by Hayek (1932) and is wholly equivalent to Mises’s ([1949] 1998) malinvestment. Garrison (2004) shows graphically how these forced savings affect the structure of production leading to a ‘dueling’ production structure (Cochran 2001).
The rational expectations hypothesis is often brought up as a refutation of this theory (e.g. Wagner 1999, Cowen 1997). Evans and Baxendale (2008) nullify this argument introducing entrepreneurial heterogeneity in a prisoner’s dilemma setting based on an article by Carilli and Dempster (2001). This use of the prisoner’s dilemma illustrates the limits of rationality. Many investors may well be aware of the fact that a policy-induced credit expansion increases nominal rather than real savings. Some may even be aware of the boom-bust consequence. However, since central authorities have the sole right of issuing legal tender, investors (but even more so, banks) can externalize the cost of recessions towards (other banks and) the taxpayer (Hayek 1933). In fact, profit-maximizing investors must increase their lending or their competition will (King 2016). The incentive for the individual makes the collective system worse off. Even though investors might thus be aware of unsustainable lending practices, they are competitively forced into this behavior. In the words of Carilli and Dempster (2001), ‘banks need not be fooled or tricked into increasing lending’ (p. 324) but their customers will be fooled. The majority of customers is ignorant and just seeks the lowest price forcing banks to compete while unaware of the unsustainable system. Even the educated customer is ‘bribed’ into foolish behavior—in a macroeconomic sense—because he will otherwise get outcompeted by the ignorant ones (Garrison 1989, Block 2001). The result is that economic agents (no matter their background) are ‘pushed up’ the boom phase of the cycle towards margin lending because strategic behavior induces them to. This imposes clear restraints on the impact of rationality. The ‘search for yield’ systematically moves lenders towards riskier investments. Bloomberg (2016) writes: “Credit fund managers who, having largely sat out on the recent rally in junk-rated debts, now find themselves forced to re-enter the fray after underperforming the wider market” (emphasis mine). Additionally, Hendrickson (2017) finds that investment by firms at lower interest rates is increasingly more prone to coordination failures, adding to risk and uncertainty.
Mulligan (2013) argues that the ABCT shows resemblance with Minsky’s (1992) Financial Instability Hypothesis (FIH) in which a first mover advantage is present for lenders (borrowers) extending (taking on) more credit (debt). This means that the prisoner’s dilemma works over both the extensive and intensive margin: who is in/out, and who is first? Thus not only does excessive credit expansion lead to moral hazard, it also allows an adverse selection problem to materialize since margin lending (borrowing) lures ‘bad’ entrepreneurs and non-creditworthy borrowers into the market (Evans and Baxendale 2008). Moreover, informational cascades (or Cantillon effects) increase investor-consumer inequality due to a knowledge gap which in turn is amplified through the adhesive power of the financial sector (Howden 2010). Resource misallocation along the structure of production shifts focus and resources away from the real sector. Entrepreneurial knowledge is extracted by the financial sector leaving the real sector at a serious knowledge disadvantage on how to align consumer demands along the structure of production.
1.3 Empirical Approaches to the Structure of Production
According to Lewis and Wagner (2016) Austrian macro theory suffers from an underdevelopment in the use of empirics to support theory. Expanding on those, or developing new ways to empirically support theory would, according to the authors, make Austrian macro theory able to compete with mainstream dominance. Examples of empirical Austrian research are Mulligan (2006), Fillieule (2007), Young (2012) and Cachanosky and Lewin (2014) amongst others. Not surprisingly, they all relate to the Hayekian triangle in one way or another.
Mulligan (2006) for instance finds that lowering the interest rate below sustainable market rates provides a short-term boost to consumption and investment, but has a decreasing effect in the long run. This is in line with the ABCT. Fillieule (2007) mainly analyzes the goods-in-process structure of production and finds that a lower time preference is followed by a lengthening of the production structure in which the profitability of earlier stages relatively increases. While this provides some concrete results, he uses a formalized form of the average production structure concept of Böhm-Bawerk (1891) to counter the infinite-stages problem. Economists like Garrison (1981) argue this to be a futile attempt to quantify a series of subjective numbers into one value. An alternative approach by Cachanosky and Lewin (2014), though also based on an average production period, uses the economic value-added (EVA®) literature which allows them to ‘reframe roundaboutness and interest rate sensitivity into financial terminology’.EVA® is a registered trademark of Stern Stewart and Co. (Cachanosky and Lewin 2014). In their review of the triangle, they effectively determine that, due to its nature, empirical research is prone to subjective judgment because of the very structure of the triangular concept. The authors do endorse the approach taken by Young (2012) who qualitatively examines the impact of interest rate deviations on the aggregate roundaboutness of the Hayekian triangle rather than on specific stages. Young’s analysis of the 2002–09 US structure of production is relatively simple but elegant. He develops a ‘total industry output requirement’ (TIOR) as an indicator for roundaboutness. I will expand on his work by taking this indicator to a country level. The breadth of my dataset allows me to assess the economy-wide roundaboutness of 28 countries. This generalization, however, comes at the cost of not being able to assess individual country characteristics. Based on regression analysis, I expect similar results to match with ABCT in the sense that the production structure of an economy will expand with a larger interest rate gap.
- METHODOLOGY I use cross-country regression analysis to examine whether there are generalizable effects of a larger interest rate gap on the roundaboutness of economies. I approach roundaboutness by creating a similar metric to Young’s (2012) TIOR which I call TEOR, or, the ‘total economy’s output requirement’. The TEOR of a specific country reflects the amount of gross output required from its domestic industries both directly and indirectly to deliver a currency unit of final output.
Figure 1. A Simplified Hayekian Triangle
The TEOR is defined as the ratio of gross output to final output (excluding foreign inputs for simplicity). To illustrate, in Figure 1 I present the Hayekian triangle with intermediate and final outputs. The TEOR value is the surface of the triangle (total gross output) divided by the shaded part (final output). Formally, consider that the economy consists of an array of industries indexed by . Industries process intermediate (capital) goods yielding value added, denoted by , equal to final output (Garrison 2002). According to the Bureau of Economic Analysis, value added equals the difference between an economy’s gross output and the cost of its intermediate inputs.See https://www.bea.gov/faq/index.cfm?faq_id=1034. Industry gross output is denoted by .
Total gross output is then given by
from which the TEOR can be derived as,
By definition, a relative increase in the production of intermediate goods increases TEOR. Assuming no monetary intervention, such a situation occurs when the average relative time preference of consumers decreases. Conversely, a relative increase of final output decreases TEOR which occurs when the average relative time preference of consumers increases. This allows TEOR to function as an interpretation of roundaboutness which is an important step in the empirical analysis of ABCT.
To measure the interest rate gap, I take the difference between a country’s market interest rate (i.e. the short-term interest rate) and the natural interest rate. I proxy the latter following the original equation of Taylor (1993):
To simplify, I follow Taylor’s (1993) rule of thumb to attach 0.5 weights to and . I specify as the output gap which then yields,
where is the market interest rate that should be targeted, is the current core CPI inflation rate, is the desired inflation rate and is the estimated value of the equilibrium real interest rate. The latter’s estimations differ (Yellen, 2015) but I will follow Young (2012) and Taylor (1993) by setting it to 2 percent. A desired inflation rate of (close to) 2 percent is commonly accepted in OECD countries hence I equally standardize that rate. Natural rate estimation then follows:
(5)
Combining this with the actual market rate, the interest rate gap is calculated as:
(6)
The baseline regression then estimates the relation between the interest rate gap and roundaboutness:
(7)
where and respectively denote country and year. To recognize country heterogeneity, I control for time-invariant country characteristics in the intercept. Absolute differences between the two interest rates are useful because it allows for assessing the impact of sustained gaps. A production structure might not instantly adjust to a one-off deviation. Negative gaps ( ) pose no problems to the expected outcome since its reverse equally holds true (Rosen and Ravier, 2014).
Given the likelihood of a dynamic relationship and potential autocorrelation, I include lags of both variables and assume (trending) stationarity. Additionally, interest rates changes—often piecemeal—are subject to the Cantillon mechanism resembling distributive effects. Similarly, TEOR is also dependent on its previous values since economic growth is equally gradual. The possibility to detect the movements of both variables could be improved using quarterly or monthly data which I unfortunately do not have.
A consequence of using the ARDL model is the violation of the assumption that the dependent variable is uncorrelated with the error term—ARDL implies autocorrelation. To eliminate this, I include sufficient lags of both variables such that lagged errors can be excluded. The optimal lag amount minimizes the Akaike and Bayes information criteria. I further control for demographics since this is known to push down interest rates (Rachel and Smith, 2015; Carvalho et al., 2016). The ratio of old population (age > 65) to total population captures this effect.
To assess the elasticity of specific production stages to interest rate gaps, I follow Young (2012) and average respectively the five most roundabout (MR) and least roundabout (LR) industries into two ‘TIOR’ rates. The goal of creating these two averages is to examine the difference in cyclical sensitivity between early and late stages. Last, the CI and LTI proxy function as alternative to the Taylor proxy. Interest rate gaps are:
(8)
(9)
The CI proxy is inspired by Carilli et al. (2008) but modified following Rothbard (2009) who points out that the proportion between consumption and investment (rather than saving) reflects individual time preferences.
- DATA One of the main contributions of this paper is to construct a unique data set on Gross Output for 28 OECD countries over the years 2000–14.See Appendix A for a country overview. Underlying data has been retrieved from the World Input-Output Database (WIOD) 2016 release (Timmer et al. 2015, 2016). Specifically, I extracted annual data from 28 different National Supply and Use Tables (SUTs) corresponding to the OECD countries. The database is classified according to the ISIC Rev. 4 and its tables are based on SNA 2008. To retrieve GO per country, I use ‘total intermediate consumption’ (column labeled ‘INTC’) for GO—at basic prices—from the Use tables. This includes value added (at basic prices) plus intermediate inputs adjusted for taxes less subsidies. I calculate GDP as total value added of all industries using the same source (taxes and subsidies excluded).
Necessary data for the Taylor-rate equation are collected from several sources. The realized market interest rates per annum are retrieved from the OECD database on short term interest rates, with the exception of rates for Hungary, Japan and Slovenia which were collected from AMECO. Core CPI rates and output gaps are respectively from the OECD and AMECO database. Data on the old population ratio is from the World Bank Development Indicators (WDI). I calculated the consumption-investment interest rate proxy using data from the WDI. Specifically, I use Gross Capital Formation (as percent of GDP) and Final consumption expenditure (as percent of GDP). The long-term interest rate is proxied by OECD government bond data except for Estonia, Slovak Republic, and Slovenia, which are from the AMECO database. Some years are missing: Czech Republic (2000), Estonia (2011–14), Korea (2000), Mexico (2000, 2001), Poland (2000), Slovenia (2000, 2001).
Table 1. Descriptive Statistics Including Variable Definitions
MR and LR are calculated using underlying data from the national SUTs of the WIOD. One exception is made for Japan, where one of the five least roundabout industries, household activities, was calculated in a seemingly inconsistent way—I used the sixth least roundabout industry instead. According to Rosen and Ravier (2014), a new business cycle began around December 2000, hence I use 2001 as the base year to determine MR and LR.
The panel data are strongly balanced (N = 420). For further descriptives, see Table 1. Most variables are complete except for the LTI proxy. TEOR is relatively normally peaked but slightly skewed rightwards. MR has a few large outliers which might bias the estimators—normalizing solves some of the skewness. LR is more normally distributed but somewhat skewed to the right. The MR–LR distributional difference makes sense from a theoretical perspective. The included 65 industries roughly follow a Pareto-like distribution where MR industries are relatively more dispersed and further from the mean than LR industries. Taking the average from a sample of 10 industries to mitigate this difference barely affects LR but greatly affects MR potentially risking diluting its elasticity to the interest rate gap.
- ANALYSIS 4.1 Baseline results
I use a panel fixed effects baseline ARDL regression with clustered robust standard errors to counter heteroskedasticity in the error variance. A unit root test rejects non-stationarity. To determine the optimal lag amount for TEOR and the interest rate gap I add to both variables up to 5 lags and subject each specification to an AIC/BIC test. This suggests an ARDL(1,0) process to be optimal for modeling the relationship. A manually performed RESET test confirms that the model does not suffer from omitted variable bias. To check whether serial correlation has been eliminated, I compare the ARDL(1,0) process to eight other variations and again subject them to an information criteria test. To visualize the variations:
The model comparison shows that the ARDL(1,0) process remains to be the best fit. BIC results correcting for observation loss—due to added lags—points in the same direction. Note that it is not a certainty that autocorrelation in the error term is completely eliminated, but it is as much as possible.
Table 2. Comparison of the relationship between TEOR and the interest rate gap based on three different proxies. The dependent variable is logTEOR.
Robust standard errors in brackets * p<0.01, p<0.05, * p<0.10 To compare the Taylor-based ARDL process to the other two proxies, I run through the exact same process to determine the most optimal amount of lags for both specifications. Results suggest an ARDL(1,1) and ARDL(1,0) process for respectively the CI and LTI proxy. A comparison of the TEOR responding to all three proxies is provided in Table 2. Column 1 shows that a Taylor-based interest rate gap of 1 percent significantly results in a 0.11 percent more roundabout economy, ceteris paribus. Thus, GO increases with 0.11 percent as compared to final output, a difference in difference effect. The second column displays contradicting results and with a zero net effect does not support ABCT, whereas results in column 3 are insignificant alltogether. I want to make two additional remarks. First, I left out the control variable for the LTI proxy because demographic effects are already captured by the long term government bond interest rate (Rachel and Smith, 2015). Second, note that I included a test whether the adjusted R-squared in fact increases upon adding r_gap (and its lags) to the specification, indicating its relevance.
4.2 Cyclical Sensitivity and Country Conditions
I now substitute TEOR with MR and TR and run through the same procedure for lag and model optimization. Significant outcomes are for MR combined with the Taylor proxy and for LR combined with the CI and LTI proxy. Other variations return insignificant results. I provide the significant results in Table 3. Interestingly, the MR response to the interest rate gap is negative for the contemporaneous year but positive for its first lag. A prolonged (t>1) interest rate gap of 1 percent results in a net positive effect on roundaboutness of around 0.65 percent.
Table 3. Comparison of the average TEOR to stage-specific TIORs. DEPVAR refers to the relevant dependent variable specified below the column number.
Robust standard errors in brackets * p<0.01, p<0.05, * p<0.10 The responsiveness to an interest rate gap of the most roundabout industries is 5 times larger than that of the least roundabout industries (0.14–0.21 percent), providing the gap persists during at least two successive years. This suggests that more remote industries are as expected more elastic to interest rate changes. The CI and LTI proxy are inherently less volatile and might therefore explain the non-significant responses of MR. Conversely, the same reasoning might apply to LR estimations.
Finally, I check whether the baseline Taylor-based TEOR results are robust to specific country conditions (table not reported). In particular, I include three additional control variables on their own, and as interaction with the interest rate gap. First, I look at the growth rate of financial depth and proxy this with the growth rate of liquid liabilities as a percentage of GDP (King and Levine 1993). Second, I use R&D expenditures growth (as percent of GDP) to proxy capital intensity. Third, I use stock market capitalization growth (as percent of GDP) to determine the impact of financial sector development. A developed financial sector is generally associated with economic growth and better resource and capital allocation (Allen and Gale 2000, Levine 2002). For every addition, I re-run the lag and model optimization process to determine the most optimal ARDL specification. None of the three added control variables, nor their interactions with the interest rate gap, significantly changes the earlier results from Table 2.
- DISCUSSION AND CONCLUSION 5.1 Discussion of the Results
A positive relationship is found between TEOR and the Taylor-based interest rate gap. The outcome is both significant and economically relevant. Over the observation period, GO shows a relative growth rate of 0.11 percent to GDP for every percent increase in the interest rate gap. This translates approximately into a 0.22–0.33 percent change in GDP terms (i.e. TEOR rate* ∆GO). For a small (big) country like Belgium (United States) this means hypothetical capital misallocation of EUR 920 million (USD 34 billion) in 2014. In the upswing of a business cycle, capital misallocation accumulates over the years and pushes the economy beyond its maximally attainable production possibilities frontier until the inevitable correction sets in (Garrison 2004). A back-of-the-envelope calculation provides further color to this scenario by suggesting more capital misplacement results in deeper downturns (see Appendix B).I note two caveats here. The amounts mentioned for capital misallocation are hypothetical in the sense that it is impossible to know what share of capital is easily redirected during economic recovery and what part is plainly wasted. It is thus equally impossible to accurately determine the accumulated stock of misallocated capital the moment before a boom turns into a bust. The amounts are merely provided to give an impression of the magnitudes potentially affecting the production structure of an economy.
Figure 2. The Dueling Hayekian Triangle
Source: Garrison (2004). Policy-induced interest rates suggest an unsustainable increase in the capital-intensity of the economy potentially initiating an Austrian boom-bust cycle. Artificially low rates provide a short-term boost to both final output and gross output. ABCT predicts the latter effect to be dominant and this is indeed observable in the results. Early stage industries respond up to 5 times stronger to (prolonged) interest rate gaps than late stage industries. Early stage—more roundabout—industries act more pro-cyclical and more volatile due to time-value of money effects (Skousen 2015). Interestingly, MR industries also require a multi-lagged model suggesting they are also more sensitive to delayed interest rate effects. The fact that the average TEOR response is smaller than the lower-bound LR response may seem odd. A possible explanation for this behavior is that the average response is likely similar to a response from middle stages. In a ‘dueling’ Hayekian triangle setting, middle stages are relatively negatively affected due to misallocated capital (Cochran 2001, Garrison 2004). This results in a kink in the hypotenuse (see Figure 2). The potential relatively negative effect of the middle stages might have pulled down the economy wide average industrial response to an interest rate gap.
ABCT is particularly consistent with Minsky’s (1992) FIH which describes that extended periods of economic prosperity lead to under-evaluation of market risk inducing firms and other market participants to increase investment (Mulligan, 2013). While this process of progressive overleveraging is endogenous, the Austrian monetary expansion is exogenous. However, both mechanisms are prone to the influence that expansionary monetary pressure exerts on inflating the boom. Increasing roundaboutness due to interest rate gaps closely resembles a Minsky-like period of euphoria. Quite literally, due to misperception of risk variability and adjustment costs (i.e. price signals), entrepreneurs increasingly engage in plan revisions to further expand their business (Mulligan, 2013). This decreases productivity and leads to wasteful spending (Dobrescu et al., 2012).
5.2 Limitations and Suggestions for Future Research
Based on the constructed dataset, I put forward some suggestions I chose not to pursue in the current paper. First, different natural rate proxies could be used to calculate the interest rate gap. Labauch and Williams (2003) provide such an alternative, albeit technical, as well as Keeler (2001) who uses a term spread technique, which however should be slightly adjusted to meet the critique of Carilli et al. (2008). Second, the Taylor rate could equally be established differently. Here, both the proposition of Yellen (2015) to modify the real equilibrium interest rate or a non-generalized inflation rate to match specific countries’ past and present inflation targets could be followed.
Others interested in this topic but rather on a country level could combine the methodology of Young (2012) and the dataset of the present paper. This could yield 27 additional qualitative country-specific studies on production structures and would greatly expand the knowledge of Austrian business cycles in each of those countries. Additionally, these studies could be extended with an empirical VAR analysis including a Granger-causality check á la Carilli et al. (2008), which is quite laborious for panel data. If employing VAR, longer time series would then be desirable (e.g. by adding more years or finding quarterly or even monthly data).
Furthermore, the methodology of this paper could be used for within country panel analysis on the industrial level—each industry has its own TIOR. Data for this can be retrieved from the national SUTs of the WIOD (Timmer et al., 2015). In fact, the Young analysis could even be applied to a singly industry within or cross-country.
5.3. Conclusion
The empirical analysis of this paper confirms that Austrian boom-bust dynamics are economically relevant and do not just remain ABCT artifacts. I have employed an autoregressive distributed lag model to analyze historical data related to the production structure of 28 developed economies. I found that policy-induced deviations from the natural rate of interest increases roundaboutness and could instigate an unsustainable boom. Additionally, I found that early stage industries have higher cyclical sensitivity than late stage industries confirming the importance of time-value dynamics in the structure of production (Skousen 2015). I used three natural rate proxies the significance of which varied across the different dependent variables. The Taylor proxy applies best to average economic as well as early stage roundaboutness, while the alternative proxies are a better fit for late stage roundaboutness. Even though these differences can be explained to a certain extent, further research on these causes is warmly welcomed.
Appendix A. Overview of Countries Included in the Dataset
Source: Timmer et al. (2015). Note: I use GO/GDP ratios hence currencies play no role. Appendix B. Cross-Country Boom-Bust Statistics
Note: Capital misallocation is the cumulative sum over the years 2001 until the year before a downturn. For some countries this exceeded 1 year of negative growth in which case I also included the next year in Δ GDP during downturn. As the scatterplot shows, some countries did not experience a clear boom-bust scenario. Excluding these from the results does not change the significance of the correlation coefficient.
Abstract: This paper aims to propose a non-distortionary monetary policy objective consistent with the Austrian business cycle theory. Since the price level should fall in the growing economy in the Hayekian framework, introduction of a negative inflation target combined with the Taylor rule is suggested as a non-distortionary monetary policy. To keep the money stream stable, the optimal inflation target would be equal to the opposite of the growth rate of the economy. Such policy should lead to the smoothing of the business cycle path since monetary policy could be less activist compared to the current state of the positive inflation target. Possible criticisms of this suggestion are anticipated and addressed in this paper.
central bank inflation targeting negative inflation taylor rule monetary policy business cycle JEL Classification: B53, E31, E32, E52, E58 Tomáš Frömmel (tomas.frommel@vse.cz) is a Ph.D. student in the economics department at the University of Economics, Prague.
INTRODUCTION Some economists from the Austrian school tend to criticize the existence of the central banks and suggest their abolition and transition towards a free banking system. Nonetheless, the existence of the central banks is a state that apparently cannot be changed, at least in the near future. For this reason, suggestions of the central banks’ abolition cannot be taken seriously, since they are far away from current reality. Although it may be true that the economy would develop better without the central banking system, Austrian economists might come up with some more realistic suggestions of rules for central bank policy.
The aim of this paper is, therefore, to develop a non-distortionary monetary policy objective consistent with the Austrian business cycle theory. The central bank committed to such an objective should not lower permanently the market rate of interest below the natural level, and would not distort free-market system of relative prices and trigger artificial boom-bust cycles.
The introduction of a negative inflation target combined with the Taylor rule is suggested as a satisfactory policy objective, complying with requirements presented above. Since, in the Hayekian framework, the price level should fall as the natural output of the economy grows, monetary policy could be less activist compared to the current state of positive inflation rate targeting; relative prices would not be distorted by permanent injections of new money into the economy and the course of economic development could be smoothed under the proposed rule.
There have already been some suggestions that the price level should be allowed to fall in the growing economy (e.g. Hayek 1935, Friedman 1984, Selgin 1997, or Potužák 2016). Unlike these papers, this essay respects the fact that current central banks do not target money supply and rather use interest rates as their policy instrument. Therefore, we aim to propose a non-distortionary rule prescribing how the central bank might set its interest rates. For this reason, our suggestion might be more realistic compared to the other suggestions.
The structure of the paper is as follows. The first section briefly presents monetary policy rules and especially the inflation targeting regime and the Taylor rule. The second section presents criticism of the inflation targeting from the Austrian perspective. The next section suggests the introduction of a negative inflation target and explains advantages of this policy. The last section aims to anticipate possible criticisms of the suggested policy and tries to disprove them.
- INFLATION TARGETING AND THE TAYLOR RULE Monetary policy rules are commonly seen as more convenient than discretionary policy (Sargent and Wallace 1975, Barro and Gordon 1983, or Svensson 1999). The main argument in favor of policy rules is the problem of time inconsistency of the central bank policy. A central bank committing itself to some policy rule should not adopt any policy that has not been declared in advance. Policy rules may thereby reduce entrepreneurs’ uncertainty concerning future monetary policy conditions, and the central bank becomes more predictable.
Furthermore, if arguments of the Austrian business cycle theory critics (e.g. Tullock 1988, Cowen 1997, or Wagner 1999) were right, monetary policy rules should lead to gradual smoothing of the cyclical development of the economy. If the central bank adopted and publicly communicated some policy rule, monetary policy would become more transparent and entrepreneurs would be able to understand the consequences of central bank policies more easily. Then, they would not be fooled by the monetary authority and an artificial boomThe Austrian business cycle theory (Mises 1953, Hayek 1933 and 1935, or Garrison 2001) predicts that lowering the market rate of interest below its natural level and subsequent non-uniform inflow of new money into the economy leads to investment into more roundabout production processes. Since increased investments are not accompanied by increased voluntary savings, newly created structures cannot be finished in the future. The economic boom is not sustainable for this reason, and the recession is an unavoidable result that allows re-equalization between real savings and investments. would not be triggered. To adopt a policy rule seems to be a suitable action since it limits the central bank’s ability to increase the amount of money in the economy and hereby initiates artificial boom-bust cycles.
One of the most common monetary policy rules or regimes is inflation targeting, defined by Bernanke and Mishkin (1997, 97) as “the announcement of official target ranges for the inflation rate at one or more horizons and… explicit acknowledgement that low and stable inflation is the overriding goal of monetary policy.” This regime of monetary policy is defended mostly for its high transparency and comprehensibility. A credible central bank may, by setting and publicly communicating its inflation target, simply control inflation expectations of agents in the economy and hereby control the inflation rate (Bernanke and Mishkin 1997). Furthermore, Svensson (1999) states that the inflation targeting regime helps to maintain low and stable inflation rate in the long run.
Taylor (1993) suggests a policy rule that allows the central bank to respond to the output gap and to the difference between the actual inflation rate and target for the inflation rate. The rule may be expressed by the following equation according to Mankiw’s (2009) macroeconomics textbook:Taylor (1993) assumed specific values of parameters ρ, πT, θπ and θY. Mankiw’s (2009) equation is written without any assumptions for parameters and variables.
(1)
where i denotes the central bank’s nominal rate of interest, π stands for the rate of inflation, πT is the central bank’s target for the inflation rate (set as a positive number), (yt – y*) expresses the percentage difference between current real output of the economy and its natural level, ρ is the natural rate of interest, and parameters θπ and θY express responsiveness of the central bank to changes in the inflation rate and to the deviations of real output from its natural level. Parameters πT, θπ and θY are set by the central bank. Money supply is endogenous under this rule.
The Taylor rule implies that if the rate of inflation is on the target and output does not deviate from its natural level, the central bank should set its nominal rate of interest equal to the nominal equilibrium rate of interest ρ + πt. If the rate of inflation decreases below the inflation target, the central bank should decrease its nominal rate of interest and vice versa.A sufficiently strong decrease in the central bank’s rate of interest pushes the real rate of interest downwards, below the natural level. This stimulates investments and consumption and increases the rate of inflation, which is hereby stabilized at its target.
Despite its several critics (e.g. Orphanides 2001, or Orphanides and Williams 2002), some version of the Taylor rule is used in models of new Keynesian economists (e.g. Clarida, Galí and Gertler 1998, or Svensson 2000a).
- INFLATION TARGETING: AN AUSTRIAN PERSPECTIVE Let us now assess the policy of inflation targeting from an Austrian perspective. The first problem may arise with the definition of inflation. While Austrian economists usually define inflation as an increase in the quantity of money in the circulation, mainstream economists usually speak of an increase in the aggregate price level (Bagus 2003). For purposes of this paper, let us accept the mainstream definition; inflation means a rising price level and may be measured by the consumer price index or by the GDP deflator.
Another, more serious, problem arises with targeting the positive inflation rate in the growing or stationary economy. While all central banks targeting inflation have positive inflation targets, Hayek (1928) suggests that if the quantity of money is held constant, prices must fall if the output rises and vice versa.
Hayek (1935) further argues that in the growing economy, the equality of the natural rate of interest and the market rate of interest is feasible only in case of the falling price level; price level should not be stabilized in the growing economy.Wicksell (1936) argues that the market rate of interest is equal to its natural level in case of stabilized price level. Hayek (1935) objects that this holds only in the stationary economy. Further discussion on this issue may be found in Potužák (2018).,White (1999) points out that Hayek (1976) not criticizing price level stabilization is not consistent with his previous works. Komrska and Hudík (2016) reject this alleged inconsistency. If prices are intended to rise or remain stable in such an economy, the central bank must permanently increase the amount of money in circulation, and it thereby creates permanent pressure for the reduction of the market rate of interest below its natural level.This holds regardless whether the central banks control interest rates or the money supply. An attempt to stabilize the price level in the growing economy leads to an increase in the money supply and to a decrease in the rate of interest below its natural level.
This may be simply shown using the quantity theory of money and the equation of exchange:
(2)
where M expresses the money supply, V velocity of circulation of money, P aggregate price level and Y real output. The expression MV on the right side of the equation 2 may be called nominal income of the economy.
Equation 2 implies that in case of a stable velocity of money and a stable money supply, nominal income is stable as well; then, if real output rises, the price level must fall. A permanent increase in the price level in an economy with growing natural output unambiguously implies the necessity of a permanent increase in the money supply or velocity. Targeting a positive inflation rate in the economy with growing or stationary natural output necessarily implies permanent pressure for the reduction of the market rate of interest below its natural level, which according to the Austrian business cycle theory, distorts the free market system of relative prices and triggers an artificial boom. Potužák (2018), therefore, shows that inflation targeting (or price level stabilization) is not a suitable policy in the economy with growing natural output; price level may be stabilized only in a stationary economy.
Furthermore, inflation targeting leads to the distortions in the free market system of relative prices (Cochran 2004). An increase in the price level due to an increase in the amount of money in circulation is never uniform; some prices rise and some may even fall when the central bank injects new money into the economy (Mises 1953). Selgin (1997) describes a case of a decrease in only one individual price due to a positive shift in technology while all the other prices remain unchanged. In such case, aggregate price level slightly decreases, and the central bank needs to increase the money supply to stabilize it. Thus, after a decrease in only one individual price, the central bank aiming to stabilize the price level changes all the prices in the economy. Selgin (1999) states that even Hayek realized that attempts to stabilize the price level if real output rises lead to serious dislocations of relative prices.
The last objection deals with the central bank’s alleged ability to simply control inflation expectations in the economy. This might be true; nevertheless, Murphy (2005) proposes that entrepreneurs need not care about all prices in the economy or about the aggregate price level. What matters in entrepreneurs’ decision-making are expectations about only a small set of market prices; entrepreneurs need to know only prices of their inputs and outputs. Since an increase in prices after monetary expansion is never uniform (Mises 1953), inflation expectations are different from expectations of individual price movements. All individual prices may change even in case of price level stability; hence, entrepreneurs may expect a change in a small set of prices even in case of a stabilized price level. Furthermore, some individual prices may decrease even in the case of an increasing price level. The presumed advantage of the inflation targeting regime might be hereby partly disproved from an Austrian perspective since the central bank does not possess the ability to control individual-price expectations, but only price-level expectations or inflation expectations.Inflation targeting might be probably problematic from some parts of mainstream economics (i.e. Lucas 1972) as well since it targets something that no single agent in the economy uses as his benchmark.
To sum up this section, it seems that inflation targeting suffers from several serious objections and, from an Austrian point of view, should not be evaluated as a suitable regime of the central bank policy in the growing economy. In the next section, we will introduce a rule that might be more convenient from the Austrian perspective.
- SUGGESTION OF THE NEGATIVE INFLATION TARGET There have already been some attempts to suggest a monetary policy rule that would not initiate boom-bust cycles in the growing economy. Hayek (1935) proposes that the central bank should not stabilize the price level, but rather money stream defined by the total nominal spending in the economy. Potužák (2016) explains that only keeping the money stream MV constant protects the economy against adverse effects of shocks to the velocity of money circulation that are similar to the effect of shocks to the money supply. Under Hayek’s (1935) rule,Potužák (2016) uses the term ‘Hayek MV-rule.’ money supply changes only in case of velocity changes; the central bank compensates changes in velocity of money circulation by opposite changes in the amount of money in the economy. Under such a rule, the price level would fall in the economy with growing natural output, which is consistent with the Austrian view presented in the previous section.
Nevertheless, currently central banks usually do not control the money supply but set nominal interest rates to keep the money growth within a certain interval and to fulfill their objectives. For this reason, Hayek’s proposal is not further considered as a suitable rule, but the suggestion of stabilizing money stream MV will be preserved. Some economists (e.g. Bean 1983, Hall and Mankiw 1994, West 1994, or McCallum and Nelson 1999) suggest nominal income targeting as an optimal monetary policy regime. Nominal gross domestic product would grow at a constant rate equal to the sum of the long-run average rate of growth of real output and targeted inflation rate. Nonetheless, such a policy is not significantly different from the inflation targeting. If nominal income growth is targeted, the right side of equation 2 is targeted to rise permanently. Then, the left side must grow at a stable growth rate as well, which means a permanent injection of new money into circulation. For this reason, nominal income targeting cannot be recommended as a suitable policy, since it suffers from the same problems as the inflation targeting.
As was already explained in the previous section, the Hayekian framework predicts that the aggregate price level must fall in the economy with growing natural output. Hence, introduction of the negative inflation target is suggested. The quantity theory of money and the equation of exchange is used to derive this negative inflation target. Equation 2 may be rewritten using the growth rates of all variables, obtaining the following equation:
(3)
A constant money stream MV is desired for the reasons explained above. Equality of the growth rate of the economy with the growth rate of potential output is assumed in the long run:
(4)
Hence, conclusions of Hayek (1928, 1935) combined with equations 3 and 4 imply the following formula for the optimal inflation target:
(5)
implying that in the Hayekian framework, the growth rate of the price level should be equal to the opposite to the growth rate of the potential output of the economy. The central bank could still use the Taylor rule and only use the equation 5 to set its optimal inflation target. Since the growth rate of the economy is roughly constant in the long run on the balanced-growth path (Barro and Sala-i-Martin 2004), target for inflation should be constant over time as well in such an economy.Campbell and Mankiw (1987) argue that an economic development has a stochastic trend and, thus, a growth rate of the economy is not constant over time. If this were true, the inflation target should be set as a long-term average growth rate of the economy and should be held constant for a longer time period. It would mean that monetary policy would not be completely neutral, since changes in the growth rate of the economy could cause deviations of the central bank’s inflation target from the optimal inflation target prescribed by the equation (4), but the central bank could simply control inflation expectations. Such a monetary policy regime could be acceptable for advocates of the inflation targeting (Bernanke and Mishkin 1997, or Svensson 1999) since their arguments in favor of the regime of inflation targeting might hold regardless whether the target is positive or negative. The suggestion of a negative inflation target incorporates a desired high level of transparency, trustworthiness and predictability of the central bank policy; by publicly announcing its negative inflation target, the central bank might reduce uncertainty concerning future monetary policy conditions and hereby control inflation expectations of entrepreneurs. Thus, from this perspective, inflation targeting with the positive target might not be more advantageous compared to the suggested negative inflation target policy.Nonetheless, inflation targeting proponents (Bernanke and Mishkin 1997, or Svensson 1999) broadly defend positive inflation targets. Our suggestion of negative inflation target policy would probably be criticized by them, even though the central bank would remain transparent and predictable. This objection will be discussed in the fourth section.
Nonetheless, negative inflation target policy could be more suitable than the inflation targeting with the positive target. Since, according to Hayek, the aggregate price level should gradually decrease in the economy that is going through technology-induced growth, monetary authority need not be so activist when targeting the negative inflation rate. Positive inflation rate in the economy with growing natural output must always be induced by the central bank injecting new money into the economy; on the contrary, negative inflation may be achieved per se, without any monetary authority actions.
If the central bank accepted negative inflation target policy, adjustments of the interest rate and money supply would not be needed so often and the free-market system of relative prices should be distorted less compared to targeting the positive inflation rate. Since the central bank would not permanently lower the money rate of interest below its natural level, monetary policy would not be excessively expansionary and would not initiate artificial boom and bust cycles so often. Output of the economy would be stabilized around its potential level and the course of the economic development would be smoothed.
Furthermore, since the central bank would not intervene permanently in the money markets, a free market system of relative prices would not be artificially distorted. Entrepreneurs might be able to form expectations and predictions of their prices more easily and more accurately than in case of the positive inflation target since prices would be affected only by market forces and fundamentals and not by monetary authorities (Murphy 2005).
Finally, introduction of a negative inflation target might not mean a large change in current central bank policies. Central banks setting a negative inflation target could still use some kind of the Taylor rule; the suggestion of a negative inflation target means only a change in one parameter of the monetary policy rule determined by the central bank.
- POSSIBLE CRITICISMS OF A NEGATIVE INFLATION TARGET POLICY Besides previously discussed advantages of the negative inflation target, there might be some criticisms of the suggested policy rule. This section aims to anticipate and partly disprove them.
Firstly, the suggested policy with a negative inflation target could not ensure absolute soundness of money. The central bank would have to intervene in credit markets in case of changes in the velocity of money circulation. A decrease in velocity should be accommodated by an increase in the money supply that would keep the money stream MV constant (Hayek 1935). Nevertheless, since injections of new money into the economy are not uniform and it is not ensured that new money enter exactly to the sectors with decreased velocity, free-market system of relative prices may be distorted by an inflow of new money. This monetary accommodation is, however, desirable since otherwise the economy would suffer from stronger deflation than implied by equation 5.
Moreover, the central bank would have to intervene during the business cycle since real output of the economy equals to the potential output only in the long run, and the same holds for the inflation rate and inflation target. In the short run, since the economy is hit by supply and demand shock and goes through cyclical fluctuations, the central bank committed to the negative inflation target policy would have to intervene by adjusting the rate of interest (and hence the money supply) to stabilize the inflation rate at its target and the output at its potential. If the economy is hit by a positive supply shock (i.e. due to a drop in commodity prices) and deflation deepens, the central bank, to comply with its negative inflation target, needs to lower its rate of interest to increase the amount of money in the economy. Such policy leads to a smaller decrease in the aggregate price level and the desired negative inflation rate target is met.The other possible way to conduct monetary policy in such a situation would be not to react at all and to let prices freely adjust. We treat such policy as less suitable since the rate of inflation would not be stabilized at the target and the central bank would lose control over inflation expectations. Nonetheless, the increase in prices after a monetary expansion is not uniform and the free market system of relative prices is distorted by such an attempt to override a supply-driven price development. The Austrian business cycle theory predicts that an artificial boom might be triggered by such policy. Hence, the suggested policy might not work optimally during the recessions when the inflation rate decreases below its target, which is attainable only after monetary expansion. Hence, the suggested policy might not be called non-distortionary, but rather less distortionary.
This criticism of inflation targeting, however, holds regardless of whether the inflation target is positive or negative. Nonetheless, Mises (1953) and Hayek (1933, 1935) claim that cyclical fluctuations of the economy are induced by overly expansionary policy of the monetary authority. The previous section concluded that a negative inflation target policy restricts interventions of the central bank in the credit markets and might lead to the business cycle smoothing. Then, the inflation rate should not deviate frequently from its targeted value and the frequency of central bank interventions should be lower compared to the positive inflation-target policy. From this perspective, the negative inflation target seems to be more appropriate than the positive target, although absolute neutrality of money would not be ensured.
Secondly, negative inflation target might be criticized by New Keynesians since they commonly prefer a positive inflation rate and there occurs a widespread fear from deflation (e.g. Akerlof, Dickens and Perry 1996, or Bernanke and Carey 1996). However, Borio and Filardo (2004a) distinguish three types of deflation: the good, the bad, and the ugly. Deflation implied by the proposed negative inflation target policy corresponds to the good one, caused by an increase in labor productivity and economic growth. Hence, there might be no reason for fear from this harmless deflation. Furthermore, Sargent and Wallace (1975) suggest that fully anticipated price changes should have no effect on the economic development. If the central bank with the negative inflation target were credible enough, there would be no unexpected deflation and no harmful effects on the economy.Any differences between the actual and expected rate of inflation might be avoided to prevent the deflation spiral and potentially other adverse effects of deflation. For this reason, if the central bank decided to implement the suggested negative inflation target policy, it should be implemented by gradually decreasing the inflation target accompanied by transparent communication of the central bank, so that all people may build the decreased inflation target into their inflation expectations.,Atkeson and Kehoe (2004) and Ryska (2017) showed empirically that there is no link between deflation and depression, except for the period of Great Depression. This may be another argument against fear from deflation.
Another argument in favor of the positive inflation rate claims that even fully anticipated deflation may be harmful since it leads to a reduction in consumer spending; consumers expect further decrease in prices and postpone their purchases in order to buy cheaper in the future (Krugman 1998). Potužák (2015) rejects this argument since the optimal flow of consumption over time does not depend on a ratio of present and future prices of consumption goods. The intertemporal allocation of consumption is determined by the real rate of interest. If expected deflation leads to a decrease in nominal rate of interest, real interest rate remains unaffected and optimal flow of consumption remains unaffected as well. Hence, there is no reason to be afraid of spending postponement in case of fully expected deflation.Further discussion on this issue may be found in Kovanda and Komrska (2017).
Thirdly, the proposed policy might be criticized for the problem of the zero-lower bound on nominal interest rates. Many economists (e.g. Summers 1991, McCallum 2000, Reifschneider and Williams 2000, Svensson 2000b, or Eggersson and Woodford 2003) point out that nominal interest rates cannot fall below zero. In case of the inflation rate below the target, the Taylor rule implies the necessity of lowering the central bank’s rate of interest. Because of the zero-lower bound, nominal interest rate could not be decreased below zero, which would increase real interest rate and the central bank would not be able to meet its inflation target. One might expect that the probability of the lower zero bound attainment would be increased in case of negative inflation target since equilibrium nominal interest rates would be closer to zero, compared with targeting the positive inflation rate.
Let us solve this issue. The Fisher equation expresses the following relation between the nominal and real rate of interest:
(6)
where i denotes the nominal interest rate, r stands for the real interest rate and π expresses the inflation rate. It is obvious that the negative inflation rate decreases the nominal interest rate compared to the positive target. Assuming that the inflation rate equals its target and real output is stabilized around its potential in the long run, plugging equation 5 into equation 6 implies that under the negative inflation target policy, the nominal interest rate would be given (in the long run) by the difference between the real interest rate and the growth rate of potential output of the economy:
(7)
It may be shown that the real rate of interest is higher than the growth rate of the real output if the economy is dynamically efficient (Romer 2006), hence, if the economy does not over-accumulate capital. In such an economy, the nominal interest rate is positive in the long run (Potužák 2016). Hence, even if the central bank targeted negative inflation rate, nominal interest rate would remain positive in the long run.Nominal interest rate would definitely be closer to zero than in the case of positive inflation target.
A zero lower bound might be hit in the short run since the inflation rate may fall below the target and a negative output gap may occur during the business cycle. In such a case, the Taylor rule prescribes that the central bank should lower the nominal interest rate. Since the nominal interest rate would be close to zero in the long run, there would be only limited scope for lowering the interest rates and the zero lower bound might be hit. Nonetheless, we have shown that the course of the business cycle might be smoothed under the negative inflation target policy, hence, the zero bound on nominal interest rates should not represent a serious threat under the proposed policy rule. Furthermore, since the path of economic development should be smoothed under the proposed policy, the probability of the zero-lower bound hit should be even lower than in the case of positive inflation target. The proposed negative inflation target policy might be superior to the current policies with positive inflation targets.Furthermore, Borio and Filardo (2004b) examining 14 economies in the 19th century conclude that the zero bound was never hit when the economy experienced sound deflation driven by technological progress and economic growth. This empirical result might support our theoretical conclusions, although there were no central banks in most of countries in the 19th century, while our suggestion of negative inflation target still counts with a central bank that actively sets interest rates.
Finally, New Keynesian economists (e.g. Summers 1991, Akerlof, Dickens and Perry 1996, or DeLong and Sims 1999) claim that a moderate positive inflation rate permits maximum employment and output growth in the long run because of the downward nominal-wage rigidities. For this reason, Ball (2013) even argues for an increase in inflation targets. Deflation might lead to higher than natural growth in real wages, which would increase involuntary unemployment. Nevertheless, the question is whether a decreasing profile of nominal wages would be necessary under the suggested policy. As the economy goes through the technology-induced growth, real wages grow because of the growing productivity of labor. Nominal wages might be kept constant and decreasing price level would lead to desired increase in real wages.
Let us examine this issue mathematically. Nominal wage wN is defined as a product of the real wage wR and the price level P:
(8)
Then, the growth rate of the nominal wage may be expressed by the following equation:
(9)
Neoclassical growth modelsNeoclassical growth models are explained in Barro and Sala-i-Martin (2004) or Romer (2006). predict that in the economy on the balanced growth path (steady state), the growth rate of the real wage is given by the technology growth g. Furthermore, equation 5 expresses the idea that the growth rate of the price level under the suggested negative inflation target policy equals the opposite of the growth rate of the potential output. Neoclassical growth models predict that this growth rate is given by the sum of the population growth n and the technology growth g. By plugging these growth rates into equation 9, we obtain the following formula for the growth rate of the nominal wage under the suggested policy:
(10)
We have expressed that the nominal wage growth rate would be given by the opposite of the population growth rate.Potužák (2015) comes to the same conclusion. Hence, downward rigidity of nominal wages constitutes a serious objection against the suggested negative inflation target policy if this policy were used in countries with positive population growth. In such countries with downward rigidities of nominal wages, our suggestion would lead to higher than natural growth in real wages, which would increase involuntary unemployment.
Nevertheless, Hayek (1976), Selgin (1997) and de Soto (2012) state that rigidities in nominal wages may be strengthened by the inflationary monetary policy. If real wages are rising due to technological progress and the central bank targets positive inflation rate, nominal wages must rise by a higher growth rate than the price level. This creates an environment that limits downward flexibility of nominal wages. In an environment of a stable and expected decrease in the price level, rigidities in nominal wages could be at least partly eliminated since employees could be even willing to accept a moderate decrease in their nominal wages implied by equation 10 and a falling price level would lead to an increase in their real wages.
CONCLUDING REMARKS This paper aimed to propose an objective for the central bank policy consistent with the Austrian business cycle theory. The research was motivated by the fact that many Austrian economists suggest a banking system without the central bank. Nevertheless, the existence of the central banks probably cannot be changed. Hence, Austrian economists might aim to find a non-distortionary rule for the monetary policy.
Since the price level should fall in the economy with growing natural output in the Hayekian framework, a positive inflation target is achievable only if the central bank regularly increases the amount of money in circulation. This policy is criticized from an Austrian perspective since increasing money supply pushes the money rate of interest below its natural level hereby initiates an artificial boom-bust cycle.
Introduction of a negative inflation target was suggested in this paper. Since a constant money stream is desired from the Austrian perspective, we proposed inflation targeting with the target set as the opposite number to the growth rate of the economy.
Such a policy should be superior to the positive inflation rate target since it reduces activism of the monetary authority and smooths economic development. Furthermore, all advantages of the positive inflation targeting might be kept. Possible criticisms of the suggested policy rule were anticipated and aimed to disprove, although it is not a completely non-distortionary policy.
In our view, the main challenge for future research lies in integrating the Austrian theory of capital and business cycle into the DSGE models that are one of the building blocks of modern macroeconomics. Development of the economy under the suggested negative inflation target policy could be simulated in such framework, which could help to further disprove possible criticisms of our suggestion.
Economist Nicolas Cachanosky specializes in the overlap between capital theory in traditional economics and the capitalization of cash flows in finance. He explains the relevance of these concepts to understanding the business cycle. Then, Nicolas and Bob have a friendly disagreement over Mises’ views on fractional reserve banking. The conversation closes with Nicolas’ view on central banking policy since the financial crisis of 2008.
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Quarterly Journal of Austrian Economics 22, no. 2 (Summer 2019) full issue.
ABSTRACT: The 2007/8 financial crisis and economic recessions, much like the Great Depression of 1929, stimulated an increased interest in macroeconomics in general and business cycle theory in particular. Aside from a renewed interest in the various interpretations of Keynesianism, particular attention was devoted to the Austrian School. In the first half of the 20th century within the broader Austrian camp there existed two well-established theories that, despite their important insights, were neglected by the mainstream economics profession. However, Joseph Schumpeter and Ludwig von Mises—both members of the third generation of Austrian economists—built theories of economic depressions that, despite presenting some similarities on some particular issues, were fundamentally telling a different story. A closer look at their overall theoretical system seems to suggest that their fundamental divergences have their origin in methodological and epistemological questions. Enamoured with static equilibrium analysis, Schumpeter was led to construct a theory of booms and busts that saw these as the natural outburst of a capitalist system that was inherently disruptive and unstable. Mises on the other hand, focusing on the dynamic market process, was led to conceive of booms and busts as the inevitable consequence of systematic intervention into capitalist production by the government and its corollary, the banking system.
schumpeter mises business cycle JEL Classification: B30, B31, B40, B41, E32, E51, 01, 03 INTRODUCTION With the creation of the Federal Reserve System in 1913, mainstream economists believed that financial panics had become a thing of the past. The central bank assumed the role of deviating the economy from overheating and undercooling: when prices seemed too low as to support business investments, the Fed was supposed to intervene by pumping money into the system and prevent prices from falling. On the other hand, in the case of inflation hysteria, it had to sell government bonds and suck money out of circulation. The ability to fine tune the economy through a combination of expansionary and contractionary monetary policies, reassured many economists that large economic fluctuations would disappear.
This general optimism found its clearest expression in the writings of Irving Fisher, precursor of monetarism. In 1925 Fisher argued that the fear of an upcoming bust was unwarranted: wholesale prices remained fairly stable, and general economic conditions did not allow for any downturn (Fisher 1925). This line of thought accompanied the American economist throughout the decade as he praised Benjamin Strong’s credit expansion. “There may be a recession in stock prices, but not anything in the nature of a crash,” he wrote in 1929 in response to the bearish predictions of financial advisor Roger Babson. As the stock market collapsed the following month, Fisher was proved wrong, and all of his portfolio was wiped out (Skousen 1993). He was not alone in his over-optimism regarding the state of the economy: along with Fisher were, among others, eminent academics like Wesley Mitchell—director of the New York’s Bureau of Economic Research—and John Maynard Keynes. The latter, in particular stated, in 1927, “we will not have any more crashes in our time” (Skousen 2001, 327). The exuberant confidence in the American economy that academics had in the 1920’s spilled over the political stage. Herbert Hoover, shortly before becoming president, declared that “we in America today are nearer to the final triumph over poverty than ever before in the history of any land….” (Hoover 1928, 35).
Prior to the Great Recession, things run on the same rails. As late as 2005, Milton Friedman (1912–2006) argued that “the stability of the economy is greater than it has ever been in our history. We really are in remarkably good shape. It’s amazing that people go around and write story about how bad the economy is….” Similarly, Arthur Laffer, economic adviser under Reagan, responded to the bearish forecasts of economic analyst Peter Schiff, by saying: “I’ll bet you a penny on this one… you are just way off base. There is nothing out there… we might be having a nice slowdown, but it’s not going to be a crash” (Laffer, 2006). By December 2007, Friedman and Laffer’s predictions were proved wrong: the bursting of the housing bubble led to the most pronounced meltdown since the Great Depression.
Just like in the aftermath of 1929, the inability of economists to predict the coming turmoil in 2008, brought business cycle theory back to the forefront of economics. The majority of economists has converged in the explanation of the crisis that sees de-regulation and the volatility of the capitalist system as the culprit. This line of thought has deepened interest in the demand-shock business cycle theories as put forth by Hicks and Hansen in their 1937 IS-LM model as well as in New Keynesian economics (Christiano 2017). Yet, despite Keynes’s rise to prominence, this has not been the whole story. Distrust in the mathematical approach and in the attempt to reduce economics to a subset of the natural sciences, has also led to the revival of a paradigm that offers an alternative to the dominant Walrasian framework: the Austrian school (Neck 2014).
In the first half of the 20th century, within the broader “Austrian camp”, there existed two well-established business cycle theories which “the mainstream economics profession has chosen to ignore” (Ebeling 2010, 297). One refers here to the contributions of Joseph Schumpeter and Ludwig von Mises. Aim of the following paper is thus to lay down a comprehensive statement of these writer’s theories, accounting for both their similarities and differences. For this purpose, the paper has been divided into three broad sections. In section one their figure will be presented against the background of the Austrian school, under whose influence both scholars began their studies; section 2 will outline their methodological foundations; section 3 will analyze their theory of economic depressions and draw the necessary conclusions. A recapitulation of the findings will end the paper.
I. MISES AND SCHUMPETER AGAINST THE BACKGROUND OF THE AUSTRIAN SCHOOL Liberalism Revives Austrian Intellectual Life
Ludwig von Mises and Joseph Schumpeter were born in the latter part of the 19th century in what, after the 1866 Austro-Prussian war, became the Austro-Hungarian empire. The former in Lemberg and the latter in Triesch, both would soon leave their home and settle in Vienna: the major cultural centre of the old continent (Piombini 2017). This imperial city, in the decades which preceded the first world war, exemplified the achievements of classical liberalism (Raico 1992).
The establishment of classical liberalism in Austria began with the revolution of 1848. Before the 1850s minorities, which occupied certain geographical areas within the empire, were in the most parts confined to live within those areas, with their civil liberties being severely restricted. A case in point were the Jews who, up to 1848, were forbidden to own land in Vienna and to sojourn there for more than three days (Johnston 1981). Things began to turn around in the 1850s, and more importantly after 1866. The defeat at Königgratz ended with the failure of the Grossdeutsch solution. In the aftermath of the defeat, Franz Joseph (1830–1916) came to terms with the rising separatism emanating from the Magyar-dominated Hungarian provinces, by agreeing to the Ausgleich (Compromise) of 1867. The compromise consisted in the division of the emperor’s territory into Hungary on the one hand, and a multi-ethnic region, Cisleithania, on the other. Apart from a common customs union, monetary system, foreign and military policies, Hungary was granted autonomy in domestic affairs.
Soon thereafter, the empire began to embark on the road of political and economic liberalization. A step in this direction was taken in 1861 with the establishment of estate parliaments, but what would change its fate in the half century to come was the introduction of a new liberal constitution on December 31, 1867, which outlined the Fundamental Law on the General rights of Citizens. From now onwards “every subject was secure in his life and private property; freedom of speech and the press was guaranteed; freedom of occupation and enterprise was permitted; all religious faiths were respected and allowed to be practiced; freedom of movement and residence within the empire was a guaranteed right; and all national groups were declared to have equal status before the law” (Ebeling 2010, 38). The 1867 constitution regenerated Austrian society, creating unprecedented opportunities for minorities within the empire—amidst which the Jews were by far the most prominent—to advance economically and socially (Schulak and Unterköfler, 2011).
Most significantly this liberal environment created the conditions for the revival of Austrian intellectual life. As Mises observed, “in the climate of freedom that these statutes warranted Vienna became a centre of the harbingers of new ways of thinking. From the middle of the sixteenth to the end of the eighteenth-century Austria was foreign to the intellectual effort of Europe. Nobody in Vienna—and still less in other parts of the Austrian Dominions—cared for the philosophy, literature, and science of Western Europe…. But when the Liberals had removed the fetters that had prevented any intellectual effort, when they had abolished censorship and had denounced the concordat, eminent minds began to converge toward Vienna” (Mises 1984, 10). It was amidst the late Habsburg milieu, that the major intellectual schools of the 20th century were born. Throughout this period, Wittgenstein wrote his Tractatus Logico-Philosophicus; Mach built the foundations of logical positivism; Freud pioneered psychoanalysis and the study of the unconscious; Klimt gave birth to the secession movement in art and Carl Menger put Economics “on entirely new foundations” (Schumpeter 1969, 86).
Menger and the Austrian School
Menger’s contributions to economic theory would forever characterize the distinctiveness of economists trained in the Austrian tradition. As Hayek stressed “[What] is common to the members of the Austrian school, what constitutes their peculiarity and provided the foundations for their later contributions, is their acceptance of the teaching of Carl Menger” (Hayek 1992).
At the time Menger was writing, throughout the continent, Economic Science was dominated on the one hand by the Anglo-Saxon school and its cost theory of value, and on the other by the rising scepticism and methodological holism of German Historicism. Menger’s enterprise led to solve the problems associated with both traditions, by putting man at the centre. “Man himself” Menger stressed “is the beginning and the end of every economy” (Yagi 1993, 720–21). By stating this simple fact, he concluded that what gives an object a good’s character is not some intrinsic feature, but its ability, in the eyes of the consumer, to satisfy a human need. Value is thus never independent of human consciousness and volition (Menger 1976).
What led classical economists like Smith and Ricardo to miss this point was a methodological error. They reasoned in terms of abstract classes, and not in terms of concrete quantities of goods and services exchanged by judging consumers. The latter—Menger realized—are never faced with a decision of exchanging classes of goods—milk, bread, diamonds—but rather to buy and sell given quantities—a gallon of milk, two pounds of bread, a carat of diamond—and their value is reflected by the importance that is placed on the (relevant) unit about to be acquired or given up. It is this unit that determines the value of all other units of a given supply. By focusing on the individual and his striving for the satisfaction of his needs, Menger became “the vanquisher of Ricardian theory” (Schumpeter 1969, 86).
The discovery of the law of marginal utility was simultaneously achieved by William Stanley Jevons (1870) in England and León Walras (1874) in Switzerland. Yet whereas Jevons and Walras were enamoured with the use of mathematics and functional analysis, Menger’s approach ran through teleological and subjectivist lines. For Walras and Jevons, Economics, akin to mechanical physics, was a quantitative science, and thus required that its laws be mathematical. “As the complete theory of almost every other science involves the use of that calculus” Jevons wrote “so we cannot have a true theory of Economics without its aid. To me it seems that our science must be mathematical, simply because it deals with quantities” (Jevons 1970, 3). Of similar opinion was Walras, who went as far as constructing a theory of general equilibrium which reduced the market process to a system of simultaneous equations (Infantino 2002).
Menger had a different approach: the goal of economic science was not to build fictitious, mathematical models but to explain real world phenomena. As Lawrence White noted, “Rather than elaborating a system of timeless general equilibrium prices, which was the goal of the mathematical Walrasian system, Menger wanted to explain the forces and causes behind price formation” (White 2003, 9). Economics was for him a qualitative science: its scope was to discover and explain, by means of verbal logic, causal laws and for this purpose the use of mathematics was of no avail. As he wrote in a letter to Walras, “we do not simply study quantitative relationships but also the nature [or essence] of economic phenomena. How can we attain to the knowledge of this latter (e.g., the nature of value, rent, profit, the division of labor, bimetallism, etc.) by mathematical methods?” (Hutchison 1973, 17). In order to attain such knowledge, an economist had to employ an analytic-compositive method, which traced “the complex phenomena of the social economy to the underlying atomistic forces at work” (Jaffé 1976, 521). Menger understood the difference that separated him from the other “marginalists”, and did not hesitate to end his epistolary exchanges with Walras, arguing that “a conformity does not exist between us. There is an analogy of concepts in a few points but not in the decisive questions” (Antonelli 1953, 284).
Despite Menger’s revolutionary ideas, his Grundsätze had little impact on the German speaking world, due to the influence of the German Historical School of Wilhelm Roscher (1817–94), Bruno Hildebrand (1812–78) and Karl Knies (1821–98). Common to the members of this school was some sort of scepticism toward universal and time independent laws of economic activity (Cachanosky 2018, 251). This belief was derived from the fact that historicism “understood the world of man as a result of history…. All institutions, activities and events are put into their historic constellations and are thus unique. It is, therefore, impossible for man, and for human phenomena to follow fixed unchanging laws because everything depends on everything else and the world changes all the time” (Hauser 1988, 537). This scepticism reached its apex with the rise of Gustav Schmoller as leader of the school’s second generation. Schmoller and his followers ruled out the possibility of universal laws of social reality: every observable regularity, they contended, was the product of the social institutions prevailing in a specific context (Hülsmann 2007, 122). They denied even the validity of such principles as the laws of supply and demand- and treated economics “as a historical and practical discipline” (Gordon 1993, 8).
Given the mild reception of his Principles, Menger set out to write a second book with the aim of clearing economics from unsound methodological foundations. The result was Investigations into the Method of the Social Sciences with Special Reference to Economics (1883) which presents an articulate defence of the “analytic-compositive” method in arriving at “exact laws”: laws that are valid irrespective of time and place simply because they reflect the essential nature of the factors involved. Not surprisingly, it provoked irritation on the part of his adversaries, such that in the same year, Schmoller wrote a scathing review of the book, denouncing the Austrian Economist of having engaged in “aimless abstractions.” With his response to Schmoller, Menger (1884) gave officially birth to the methodenstreit. Here the “matter in dispute was… whether there could be such a thing as a science, other than history, dealing with aspects of human action” (Mises 1984, 12).
Mises and Schumpeter: The Third Generation
Menger’s Principles was initially intended to be the first of a four-volume treatise in economic theory. This project, however, was never realized by Menger himself, and the development of the Austrian paradigm was a task that fell on the shoulders of his major disciples, Eugen von Böhm-Bawerk (1851–1914) and his brother in law, Friedrich von Wieser (1851–1926). The framework that the Galician nobleman built, however, proved to be the essential starting point from which these two thinkers took off (Ebeling 2016).
Thanks to their publications, by the mid 1880s the Austrian tradition flourished into a school of thought (Kirzner 2001). Not only did their writings find fertile soil in Austria, but also in other parts of the world, as soon as their works appeared in English in the beginning of the 1890s. By the time that Mises and Schumpeter entered the University of Vienna in the early 1900s, the Austrian School was one of the five major schools of economic thought competing for professional influence, with many of its core ideas being absorbed by the mainstream (Kirzner 2001).When sociologist Albion Woodbury Small visited Menger in Vienna in 1903, the latter confessed to him that “It is entirely indifferent to me whether the name Austrian School be preserved. The important thing is that every economist worthy of the name has now virtually adopted every essential thing that I stood for” (Small 1924, 173).
Schumpeter entered the University of Vienna’s law faculty in 1901. Born in Triesch on February 8, 1883, Jozsi witnessed the premature death of his father—a rich textile manufacturer—at the age of four, and soon moved with his mother Johanna Gruener (1861–1926) to live in Graz. Here the two remained from 1888 to 1893, until Joanna married Sigismund von Kéler, a retired general from the Austro-Hungarian army. Thanks to the high status of his stepfather, upon settling with his family in Vienna, from the age of ten to eighteen Schumpeter attended, as a day student, the Theresianum, one of the most favored high schools by the Viennese aristocracy, and which “left an important imprint upon his personality” (Haberler 1950, 335). While his classical education was formed during his years at the Theresianum, it was upon entering University that Schumpeter was introduced to economics by Friedrich von Wieser, who had inherited Menger’s chair of political economy in 1903.
Mises entered the University of Vienna’s Faculty of Law around the same time, in 1900. He was born in Lemberg on September 29, 1881, son of Adele Laundau (1858–1937) and Arthur Edler von Mises (1854–1903), “a very well-to-do railroad enterpriser,” whose Jewish family had been ennobled the day of Mises’s birth (Kuehnelt-Leddihn 1999, 1). Young Ludwig began his primary studies in Lemberg but, as soon as the father was assigned an important post with the ministry of railways, by 1892 the he moved to Vienna and was sent to the Academische Gymnasium. (Shulak and Unterköfler, 2011). During his years at the Gymnasium— Vienna’s most prestigious school along with the Theresianum and the Schottengymnasium—he was imparted a classical education and began to cultivate his early interests in political history. By the time he finished his studies, however, Mises became disillusioned with the historical method and, feeling more attracted to problems of economic and social history, decided to study law (Mises 2009, 1–2). Under the direction of Karl Grünber—a member of the German Historical School and follower of George Friedrich Knapp—his major works during this period were on history, not on theory. Things, however, changed in 1903. “Around Christmas, 1903,” Mises recalled in his memoirs, “I read Menger’s Grundsätze der Volkswirtschaftslehre for the first time. It was the reading of this book that made an ‘economist’ of me” (ibid. 25).
The two met during these years. In 1904, after resigning as third-time finance minister to the Austrian government, Böhm-Bawerk was conferred an exclusive professorship at the University of Vienna’s law faculty. Soon after settling his new chair Böhm began to hold a prestigious Privatseminar that attracted the most eminent intellectuals of the time. Aside from Mises and Schumpeter, participants included Felix Somary, Richard von Strigl, and a group of important Marxists like Nicolai Bukharin, Rudolph Hilferding, Otto Bauer and Emil Lederer (Streissler 1990). “The opening of Böhm-Bawerk’s seminar,” Mises commented years later, “was a great day in the history of the University of Vienna and in the development of economics” (Mises 2009, 31). Apart from the lively discussions between the Böhm-Bawerkians and the Austro-Marxists, here “the contrasting stands of Mises and Schumpeter surfaced, a contrast that had its apparent roots in their different personalities no less than in their substantive disagreements on methodological and theoretical issues” (Vandberg 2015, 92). Personality-wise, the two could not have been more different: whereas Schumpeter emerged in the classroom “as the man of paradox… toying with ideas, now arguing their merits and then attacking them viciously,” Mises developed “the imperturbable intransigence of his lucid thinking” that will forever characterize his persona (Allen 1991, 39; Rueff 1994).
With regards to theoretical issues these differences were not any milder. While Mises was a declared follower of Böhm-Bawerk, Schumpeter found closest affinity to Walras and Wieser (Schumpeter 2010). While the latter had in his first years receptively absorbed Menger’s principle of marginal utility he “completely ignored the structure of reality-based price theory that Menger had laboured to build upon it” (Salerno 1999, 37). In the decades leading up to World War I, as a result of his widely-shared achievements, Schumpeter became the leading figure in the Austrian school, with his book Das Wesen having a definite impact on the fourth generation (Morgenstern, 1976). Mises’s rise to prominence would, instead, have to wait. “That they had one of the great thinkers… in their midst” Hayek observed, “the Viennese have never understood” (Hayek 1977 in Mises 2009, xx).
II. ON METHOD If one seeks to understand the theoretical differences that separate the two most prominent members of the third generation of Austrian economics, and in specific their trade cycle theories, one cannot avoid looking at their methodological underpinnings. In the case of Schumpeter, the question of method “is the necessary starting point for an interpretation of his views” (Roncaglia 2005, 420). The same is true of his contemporary, for whom questions of method are foundational to any search for scientific truth.
Methodological Tolerance and Positivism
While Schumpeter is often remembered for his sociological studies, his first works as an economist dealt with issues of methodology and epistemology. The work that introduced him to the profession, was a study, published in 1906, on the importance of the mathematical method in economic theory, which demonstrated the influence that the study of this literature had on his thinking. Already from this early paper, the reader is able to grasp how, despite being raised against the background of the Viennese school, he was “far more attracted by the views of such as Cournot, Jevons, Edgeworth, Marshall and Walras” (Schneider 1951, 54).
While his 1906 article introduced him to the field of academia, it was Das Wesen, published at the age of twenty-five, that gave Schumpeter international fame and which made him into the youngest professor of political economy in the empire and the leading figure of the Austrian school’s third generation. In Das Wesen, one is presented with “Schumpeter’s first analysis and statement of the economy’s nature and the methods and theories with which to study it” (Allen 1991, 74). Its purpose was “to dissect as exactly as possible the basis, the methods, and the main findings of pure economics in order to gauge its nature, its value, and its potential for further development.” The focal point of his exposition is the static economy, a framework “wherein all economic quantities subsist in changeless, mutually determined general equilibrium” (Schumpeter 2010; Salerno 1999, 39). All throughout, the book “breathes the spirit of Lausanne rather than Vienna” (Schneider 1951, 54).
What emerges in this treatise is what Fritz Machlup calls “methodological tolerance.” At a time in which the mind set of most professors continued to be steeped in the methodenstreit, the young economist emphasized that “we should abstain from claiming “general validity” or superiority for any method” (Machlup 1951, 146) Such a view, most probably, Schumpeter inherited it from the Theresianum where students were taught that “One should know the rules of all parties and ideologies, but not belong to any party or believe in any one opinion” (Swedberg 1991, 12). The correct method, he argued, depends on the concrete problem one is faced with explaining. One must not fall in the erroneous conclusion that methodological disputes can be settled a-priori (Schumpeter 2010, 14). This, which he calls “the pragmatic approach,” requires that “The description of the method… not be the first chapter but rather the last one.” Schumpeter’s methodological liberalism, has pushed Roncaglia to parallel his views with the epistemological relativism of Kuhn, Lakatos and Feyerabend. Similarly, Samuelson has gone all the way to define the Austrian economist, an “eclectic methodologist.” (Roncaglia 2005; Samuelson 1982, 4).
Despite his arguments against methodological absolutism, from the beginning Schumpeter had strong convictions regarding the nature of economics and its affinity with the natural sciences. Economics, was a science in his view, in the way in which Ernst Mach, intended it to be, that is relying on external observation as the basis for its scientific propositions. This stance earned him the fame as “the first real positivist among economic theoreticians” (Hülsmann 2007, 167). “For Schumpeter,” Hülsmann explains, “the only basis for scientific propositions was observation of the exterior world. And the only suitable method of economic theory was to follow the approach that had proven successful in the natural sciences. In short, he was a positivist who believed that the only method that could yield “facts” was observation of the exterior world” (Hülsmann 2007, 166). Foreshadowing Milton Friedman (1953), the great admirer of Walras insisted, in fact, that economic theorems are neither realistic nor a priori. They are at best hypothetical statements based upon arbitrary assumptions which, although being detached from economic reality, are tools that allow to deal with a wide range of economic phenomena. Thus, for example, the law of subjective marginal value is to be regarded not as a law, but as a hypothesis that enables the economist to explain price phenomena in a more satisfactory way than the old cost-of production theories. It is irrelevant, according to Schumpeter, whether the assumptions upon which theories are built and the theories themselves are realistic and true. Just like a tailor’s skirt is judged according to how well it fits his customers, theorems are to be accepted on the grounds of whether they are able to fit with the facts. It on this basis that one must accept the general-equilibrium model (Schumpeter 2010, 386).
Another aspect which is worth pointing out with regards to Schumpeter’s positivist methodology, concerns his emphasis on the quantitative aspect of Economics. Exemplary on this note are the words with which he addressed the Econometric Society in 1933: “We do not impose any credo-scientific or otherwise-, and we have no common credo beyond holding: first, that economics is a science, and secondly, that this science has one very important quantitative aspect.” A few lines ahead, he went as far as to contend that in “one sense… economics is the most quantitative, not only of ‘social’ or ‘moral’ sciences, but of all sciences, physics not excluded… There would be movement even if we were unable to turn it into measurable quantity, but there cannot be prices independent of the numerical expression of every one of them, and of definite numerical relations among all of them” (Schumpeter, 1933: 69). This emphasis on Economics as a quantitative science reflects the influence Cournot, Edgeworth, Jevons, but most importantly Walras had on his thinking, an influence which, all throughout his life, outstripped that of the Austrians. Paul Samuelson, himself student of Schumpeter at Harvard, recalls that “In his general views on economic theory, he seemed surprisingly un-Austrian. On the whole, he was much more Walrasian. He always referred to León Walras as by far the greatest economist of all time” (Samuelson 1951, 103).
In line with his intellectual predecessors, Schumpeter, starting in his early works, presented as the focal point of economic analysis the exchange relationship between autonomous quantities of goods. His was an attempt to recast economic analysis along the line of classical mechanics, which implied relegating purposeful human behaviour to the background. As Kirzner explains, “In economics, Schumpeter explains, we have economic quantities of goods undergoing mutually determined exchanges that admit of being expressed by means of mathematical functions… It is the existence of these functional relationships between all these quantities that makes economic science possible. Indeed, it is these relationships themselves that constitute the whole of the subject matter of that science” (Kirzner 1976, 69).
Apriorism, Praxeology and Methodological Dualism
In contrast to his contemporary, Ludwig von Mises constructed a theory of economics built upon Menger’s subjectivism. In the process of constructing a coherent analytical framework, the Austrian economist relied on a purely theoretical method, stressing the a priori nature of economic laws. Unlike Schumpeter who, in light of his instrumentalism came to the conclusion that methodology should be relegated to the last chapter, methodological and epistemological issues occupied the first 143 pages of Human Action (Mises 1998). The recognition of the importance of method in the development of a logically coherent theory, however, was not inborn. In his early years, as earlier noted, Mises was entrenched in historicism, believing there could be no scientific discipline outside of economic history. “I saw no possibilities for economic science when I entered the university…. I believed that there was nothing in economic life that could be made the object of scientific analysis outside of economic history. There could not have been a more consistent follower of historicism than I” (Mises 2009, 104). The reading of Menger broke the cohesiveness of this epistemological position but overall the writings of the methodenstreit did not satisfy him and in order to be at peace with himself he assumed that problems of methodology were of secondary importance: priority was to be given to the advancement of science. He soon, however “recognized the error of this stance. With each problem, the economist confronts the basic questions: whence do these principles come, what is their significance, and how do they relate to experience and “reality”? These are not problems of method or even research technique; they are themselves the fundamental questions. Can one construct a system of deduction without having asked the questions upon which the system is to be built?” (Mises 2009, 105). With this rhetorical question in mind, Mises set to disclose the nature, scope and validity of Economic knowledge, first with a series of essays epitomized in Epistemological problems of Economics (1933) and later, with Theory and History (1956) and The Ultimate Foundation of Economic Science (1962).
The starting point for an analysis of Mises’s epistemological and methodological positions must be the Vienna Circle of the 1920’s, who’s tenets he rejected (Gordon, 1994). The Vienna circle was founded by Moritz Schlick (1882–1936) and consisted of a group of philosophers who professed the ideas of logical positivism, a creed which found its roots in the classical empiricism of John Locke and David Hume. Members of the group included Otto Neurath, Rudolf Carnap, Felix Kauffmann and among others even Richard von Mises and Karl Menger, respectively Mises’s brother and Menger’s son. The central and unifying idea of these logical positivists was that knowledge about the real world is attainable only via observational experience; any proposition, therefore, that is not empirically verifiable, is either tautological or nonsensical (Ayer 1946, 2). As Gordon put it, “The essence of logical positivism can… be quite simply stated. All empirical statements, i.e., statements about the world, must be testable. If a statement cannot be tested, then it has no empirical meaning…. Only propositions that can be both true and false, depending on circumstances, convey information. Propositions that either must always be true or must always be false do not” (Gordon 1996, 33). Nothing about reality, therefore, can be known with a priori certainty.
Mises developed his ideas against the backdrop of logical positivism, upholding economics as an example of a science based upon what Kant called synthetic a priori propositions—statements that are known to be true without the need for empirical verification and that, at the same time, convey new knowledge about the world (Hoppe 1995). According to Mises, the logical positivist’s claim that no empirically meaningful knowledge is to be found outside sensory experience, was ultimately self-contradictory, for this very same claim was unverifiable. “There is an obvious objection against this doctrine, viz., that this proposition that there are no synthetic a priori propositions is in itself a—as the present writer thinks, false—synthetic a priori proposition, for it can manifestly not be established by experience” (Mises 1962, 4). For Mises, that nothing about reality could be known with certainty, was ultimately refuted by what he called the action axiom. That humans act, that they employ subjectively chosen means for the attainment of subjectively chosen ends, was, he contended both meaningful and self-evident.
The axiom action, became the starting point for all economic analysis. Every action, Mises showed, involves selecting and setting aside, i.e. choosing, something which in order to manifest itself presupposes the existence of scarcity—the fundamental economic condition. On the basis of this recognition, Mises rooted economic theory in the broader science of human action: Praxeology. The purpose of an economist, he contended, is to study the categories implied in this axiom and deduce from these the entire corpus of economic theory. To the extent that they “represent the elucidations of the fact that man acts,” the principles he arrives at, come to have a similar status to the laws of mathematics and logic. Provided that they are the result of correct deductive reasoning they are both “aprioristically true and apodictically certain” (Boettke 2012, 206). “Its statements”, Mises wrote with reference to praxeology, “are, like those of logic and mathematics, a priori. They are not subject to verification or falsification on the ground of experience and facts” (Mises 1962, 32). The Austrian economist thus echoed Menger (Herbener 1991; Gordon 2012), who against the positivists of his day argued, “Testing exact theory of economy… is simply a methodological absurdity… a process analogous to that of the mathematician who wants to correct the principles of geometry by measuring real objects” (Menger 1985, 69–70).
If Schumpeter claimed that economic propositions are hypothetical, Mises treated Economics as an axiomatic-deductive science. But the differences do not end here. More fundamentally, unlike his contemporary for whom economic theory consisted of “a box of tools” (Schumpeter 2006, 15), Mises viewed economics as that science which unveils the causal laws that govern social reality. The fact that its principles are non-hypothetical in no way prevent them from furnishing knowledge about reality. “The theorems attained by correct praxeological reasoning are not only perfectly certain and incontestable…. They refer, moreover, with the full rigidity of their apodictic certainty and incontestability to the reality of action as it appears in life and history. Praxeology conveys exact and precise knowledge of real things” (Mises 1949, 39).
Mises’s methodological apriorism rested on the conviction that a categorical difference exists between the natural and social sciences, something that empiricists à la Schumpeter denied. While in sciences like physics or chemistry the subject matters are inanimate objects, in the social sciences the subject matter is man, with his goals, preferences and his ability to reason, think, and learn from experience. This difference has important implications. The first one is that Man’s free will inhibits the ability of the researcher to conduct controlled experiments and to stipulate quantitative laws regarding given relationships. The second is that being an actor himself, the social scientist is “at the outset of his researches already in possession of the ultimate principles governing the phenomena which form the subject of his study, whereas mankind has no direct knowledge of ultimate physical principles. Herein lies the radical difference between the social sciences (and moral sciences, Geisteswissenschaften) and the natural sciences. What makes natural science possible is the power to grasp or to comprehend the meaning of human action” (Mises 1990, 9). To such an extent, physics and economics, required different methods: this he called methodological dualism.
Economics, however, was not the only branch of the social sciences: no less important was history. Even these two disciplines, however, were in Mises’s view different in nature. The former studies the necessary implications of the fact that humans act; action is seen exclusively in its general, essential form, and the principles that are logically deduced are true of any action. The mental tool of such a discipline is “conception.” On the other hand, history, studies action in its concrete manifestations: its scope is not the general, but the disclosure of the particular and the individual. The mental tool of history is “understanding” (Ferrero 2018). In disagreement with Schumpeter, Mises contended that no historical investigation could be set forth without the aid of theoretical propositions as delivered by Economics. “History must rest on theory, not to alienate itself from its proper tasks, but on the contrary, in order more than ever to discharge them in the true sense of history” (Mises 1962, 136).
III. ENTREPRENEURS, BANKERS, AND BUSINESS CYCLES Our discussion of Schumpeter and Mises’s role within the Austrian school and our examination of their respective methodological approaches, feeds into the central problem of economics: the theory of why cyclical fluctuations occur in capitalistic economies. In the case of Schumpeter, the argument was first put forward as part and parcel of a more general theory of progress: his trade cycle theory appeared as the last chapter of The Theory of Economic Development (Schumpeter 1991). Briefer presentations were then conveyed to the English world with the publication of two essays in the late 1920s, The Explanation of the Business Cycle (1927) and The Instability of Capitalism (1928). Mises’s theory on the other hand resulted from the application of Menger’s subjective theory of value to the fields of money and banking. It is in his The Theory of Money and Credit that one finds the building blocks of the Austrian Theory of the Business Cycle; its essence was then refined and restated in Monetary Stabilization and Cyclical Policy (Mises 1912; 1928). Both economists attempted, in their respective books, to tackle a macroeconomic phenomenon by formulating an analysis that took into consideration the dynamic microeconomic processes that drive the market economy. In their discontent with traditional neoclassical economics both Mises and Schumpeter could be said to have been on the same page. Yet, despite converging on these ideas, the two economists tell very different stories, a difference that can be found in their respectively Walrasian and Austrian training. Following Ludwig Lachmann (1966, 553–54) one can say that the core difference between these two approaches to economic theory and reality lies in the fact that “The validity of the Lausanne model is limited to a stationary world. The background of the Austrian theory, by contrast, is a world of continuous change in which plans have to be conceived and continually revised.”
The Insufficiency of Static Analysis
As earlier noted, in Das Wesen (1908) Schumpeter familiarized the German public with the general equilibrium model as set forth by Walras. After publishing the book, therefore, he made sure to write his maestro a letter where he promised him a copy in so far as he described himself as a “disciple” and his work an “homage” (Schumpeter 2000, 43). The copy of Das Wesen soon arrived, and one year after the publication of the book, Schumpeter decided to pay his great mentor a visit. At the time of his travel, Schumpeter had in mind of writing a book that, while departing from the set of facts characteristic of the static economy, explained how the economic system itself would generate economic development and while conversing with Walras came to see a deficiency in his analysis that would forever characterize his thinking. Not only—he realized—was Walras’s representation of the economy entirely static—in that the method of analysis relied on a general equilibrium model—but his analysis only explained a stationary economy for in his eyes the economy “does not change of its own initiative, but merely reproduces constant rates of real income as it flows along in time” (Medearis 2009, 42).
More specifically, what Walras told Schumpeter was that “economic life was essentially passive and merely adapts itself to the natural and social influences which might be acting upon it, so that the theory of a stationary process constitutes really the whole of theoretical economics and that as economic theorists we cannot say much about the factors that account for historical change, but must simply register them”. This view Schumpeter found to be profoundly unsatisfactory. As he put it: “I felt very strongly that this was wrong, and that there was a source of energy within the economic system which would of itself disrupt any equilibrium that might be attained” (Schumpeter 1989, 166). This endogenous source of energy that continuously revolutionised the economic structure, became a central theme in Schumpeter’s works. According to him, in fact, one failed to understand modern capitalism without an analysis of dynamic processes, for “Capitalism… is by nature a form or method of economic change and not only never is but never can be stationary” (Schumpeter 1942, 82).
The Banker, the Entrepreneur and the Will to Lead
How to link the logic of pure economics with the world of dynamic processes, was a problem he set forth to resolve in his Theory of Economic Development. Here “Schumpeter’s aim was to create an organic link between the circular flow and the description of development” (Madarász, 1980: 346). His, was an attempt to explain the process of economic change by considering general equilibrium as the starting point and end of his analysis. This had to be the sequence of his explanation, for it was the only one consistent with his Walrasian conviction that equilibrium represented a real state of affairs. As Rothbard noted, “To set forth a theory of economic change from a Walrasian perspective, Schumpeter had to begin with the economy in a real state of general equilibrium. He then had to explain change, but that change always had to return to a state of equilibrium, for without such a return, Walrasian equilibrium would only be real at one single point of past time and would not be a recurring reality” (Rothbard 1989, 263).
The circular flow which Schumpeter explains in great detail in the first chapter, represents an economic system, based on private property and freedom of exchange, that constantly reproduces itself. Its main feature is the absence of action, replaced as it were by “a changeless and unending round of robotic behaviour” (Rothbard 1989, 261). Individuals are faced with perfect certainty and no knowledge imperfection, responding as mere objects to the prevailing state of affairs and to the given set of tastes, techniques and resources. Consumers are sovereign, and production merely replicates consumer desires through time. As one would expect in world of no uncertainty, no space is left for neither profits nor losses: all sale receipts are fully absorbed, due to the law of imputation, by land and labour, in the form of wages and rents. Herein lies a twist in the standard analysis of general equilibrium that plays a crucial role in his theory. Under the influence of J.B. Clark, Schumpeter came to minimize the role of time in production: in equilibrium, he argued, production and consumption would be synchronized. The result was to claim that, along with residual incomes being zero, even interest had no reason to exist in the circular flow: not only the entrepreneur—the residual claimant—but also the capitalist—the interest bearer—was removed.
In the circular flow, where “routine and custom provide the motive force for business behaviour,” Schumpeter admitted of the possibility for quantitative growth; this however was not to be mistaken for development (Heilbroner 1988, 169). “Development in our sense is a distinct phenomenon, entirely foreign to what may be observed in the circular flow or in the tendency toward equilibrium. It is spontaneous and discontinuous change in the channels of the flow, disturbance of equilibrium, which forever alters and displaces the equilibrium state previously existing” (Schumpeter 1991, 64). The source of this disruption was to be found in technological progress. Population and capital growth, while possibly a manifestation of development did not constitute its engine. Similarly for consumer tastes. Schumpeter was not of the idea that consumers had the power of actively directing production. Rather it was the other way around. “The large flock of consumers does not drag forward production, on the contrary, those who dominate production… lead the consumers” (Schumpeter 1910, 74).
Technological progress consists in bringing about “new combinations”: new products, new production methods, new markets, new source of supplies or new organizational forms. The carrying out of new combinations is the manifestation of economic development, and its driving force is the entrepreneur (Schumpeter 1991, 74). These individuals, who bring innovations and move the economy beyond equilibrium, are not in any meaningful sense normal. They are “a special breed as different from the rest of mankind as grey hounds are from poodles,” for they, unlike the rest, have the will to move beyond the confines of the static world, governed by tradition, custom and experience (Hülsmann 2007, 172). In so doing they are leaders in the process of social change. “Schumpeterian entrepreneurs” observes Ferlito, “not only bring out new combinations, driving economic change; they are, also and above all, leaders able to master economic change, to dare where normal individuals stop, facing social and economic opposition and finally winning their challenge” (Ferlito 2016, 49).
One can understand the difficult in mastering the process of change, by looking at what Schumpeter considers three obstacles that drivers of change must inevitable face. Firstly, drivers of change must face uncertainty which makes the formulation of plans much harder for the economic subject. Secondly, while a new thing is not objectively harder, it is psychologically so. Last but not least, during a process of change, there is a tendency for the social environment to react against a person who wants to embark in innovation. It is in light of these three fundamental obstacles that one can deduce that, whomever actually carries out new combinations and masters a process of economic change, is ultimately a true and proper social leader. In his essay “The Instability of Capitalism” (1928, 379), Schumpeter, in fact, clarified that “Successful innovation is… a task sui generis. It is a feat not of intellect, but of will. It is a special case of the social phenomenon of leadership”. As a consequence, it is not surprising to realize that what fundamentally motivates all entrepreneurs is then, for Schumpeter (1911), not monetary profit, but three psychological desires: the dream of founding a kingdom; the will to win and the joy of creating. One can thus agree with Stephan Boehm (1990, 225) that “the picture of the Schumpeterian entrepreneur… is one of strong-willed men with vision; men of true gift defying ‘the persistence of the old regime’… and ready to take on the world.”
The way these entrepreneurs are able to embark upon their disruptive projects is by bidding away the means of production from their current employments and recombine them into new and better ways. A problem, however seems here to arise. For if in the circular flow all business revenues are absorbed by production costs, how do entrepreneurs gather the necessary purchasing power to redirect resources to their new ambitious plans? Here, to rescue the entrepreneur, appears the figure of the banker, with his newly created cash ready to be loaned out. With this new credit, entrepreneurs receive the necessary buying power to outcompete the managers of the circular flow and re-deploy existing means of production so as to develop new combinations. For this reason, the banker is an essential component in the process of capitalistic development. He is to be regarded, in Schumpeter’s eyes, as “the ephor of the exchange economy”, for with his inflationary credit “he makes possible the carrying out of new combinations, authorises people, in the name of society as it were, to form them” (Schumpeter 1991, 74).
Booms and Busts as Stages of Development
This process of disequilibrium set in motion by the entrepreneur and the banking system and the consequent cluster of innovations represents the boom period of Schumpeter’s cycle theory. As the innovative entrepreneur capitalizes on his new production technologies, he is, in fact, able to create for himself an opportunity for profit by exploiting a temporary divergence between input and output prices. After the pioneer has, using Kirzner’s (1973, 70) expression, “blazed new trails,” however, he attracts, like a magnet, imitators who are intent upon further exploiting these new profit opportunities created by these innovations. The entry of these second wave of innovators forces profits back to zero: one the one hand the increased demand for labour and land increases the prices of these factors, and therefore the costs of production, and on the other the increased supply pushes output prices down. In the meanwhile, as the new firms start reaping profits the old firms which have clung to older methods of production start making losses and declaring bankruptcy, and as the initial successful firms start repaying their debts, a general period of deflation ensues. As the innovations are completed and inefficient firms readjust to the new circumstances, the economy reaches a new equilibrium state that leaves it prepared for a subsequent wave of innovations. The depression in Schumpeter’s framework represents this inevitable, natural readjustment of the economy to the changing conditions brought about by the introduction of novel combinations on the part of entrepreneurs.
This interesting point elicits a few considerations. The first is that one is faced here with “a picture of both progress and fluctuation—a theory of development which is also a theory of the trade cycle” (Robbins 1968, 16). This idea was effectively summarized by Schumpeter (1942, 132) in his later book Capitalism, Socialism and Democracy: “the function of entrepreneurs is to reform or revolutionize the pattern of production by exploiting an invention or, more generally, an untried technological possibility for producing a new commodity or producing an old one in a new way, by opening up a new source of supply of materials or a new outlet for products, by reorganizing an industry and so on… This kind of activity is primarily responsible for the recurrent “prosperities” that revolutionize the economic organism and the recurrent “recessions” that are due to the disequilibrating impact of the new products or methods.” The second, linked to the latter, is that capitalist evolution necessarily creates by its own, natural impetus the conditions for a period of depression to occur: attempting to correct this phase, ultimately, represents an attempt to pervert capitalism itself.
Mises: Problems with Mainstream Monetary Theory
The point of departure for Mises’s business cycle was not a theory of economic development, but a theory of money. Since the days of David Ricardo, it became standard procedure, to separate the micro side of the economy from the macro part. Accordingly, the price of money, was explained by reference to a mechanical version of the quantity theory. Mises, then set out, in his Theory of Money and Credit, to solve this futile divide and present a macroeconomic theory grounded in microeconomic decisions.
Grounding his analysis on individual action, the Austrian economist gave a causal-realist explanation of how the value of money is determined and how variations in the quantity of a medium of exchange has repercussions on the real economy. Regarding the former contribution, Mises showed that, just like with any other economic good, the price of money is determined by the interaction of suppliers and demanders in the market. This argument had historically been dismissed: explaining the price of money by appealing to demand and supply analysis was considered to be prey of logical circularity, because of the nature of money as a medium of exchange. This, Mises showed, however was not so: one could still say that the demand for money is based on the price and that the price of money is dependent upon its demand by taking into account the “time dimension of the problem” (Rothbard 1989, 13). “For the solution of this problem,” he wrote, “we refer to the purchasing power of the immediate past, of the moment just passed. These are two distinct magnitudes. It is erroneous to object our theorem… that it moves in a vicious circle” (Mises 1949, 405–06).
Regarding the second problem—that of the quantity theory—Mises showed how an increase in the money supply occurs at a given time and place, and therefore cannot homogenously affect individual economic agents in the same way, as was thought by John Stuart Mill (1983). As money pours into the economy it affects certain prices and incomes first, distorting production in those particular markets and later making its way throughout the economy (Mises 1953). The negation of monetary neutrality was to form the basis of his cycle theory. According to Hayek, who in the 1930s would make further contributions in this field, “this distortion of the whole price structure” brought about by the inflationary process represents “the fundamental point which the master of all of us, Ludwig von Mises, has never tired from emphasizing” (Hayek 1970, 96).
Circulation Credit and Intertemporal Discoordination
Fundamental to a comprehension of Mises’s analysis is the separation between “Commodity Credit” and “Circulation Credit.” In analyzing the field of banking, Mises realized that these institutions perform two distinct, social functions. The first one is that of warehouse for people’s deposit. Given the risk of storing cash in one’s house, or of conducting business with money on hand, merchants would find it convenient to deposit their money proper with an entrusted banker who would then, in exchange of a fee, credit them with a demand deposit, a money substitute which they could then use for their daily transactions. Note that, in this scenario, while there has been a change in the composition of money, its total supply has remained unvaried: while checking accounts have increased, this increase has been accompanied by a proportional reduction in the amount of physical cash. The second major function that banks perform is that of credit intermediation whereby the bank acts as middleman between the economy’s savers and investors, profiting from an interest rate differential. Even in this case, the activity of the bank does not result in an increase in the total money supply: whatever is lent to the bank represents resources saved up for investment purposes by the community. This is the essential nature of “commodity credit.”
While these two banking activities, if kept logically apart, are socially useful in their own right, their combination creates the condition for the emergence of “circulation credit”, the engine that sets in motion the business cycle. What happens in this scenario is that the bank begins to treat its demand deposits, entrusted by its customers for safekeeping, as available savings to be lent to the public, by creating bank notes and/or demand deposits unbacked by an increase in reserves. These are then lent to willing borrowers, who embark upon investible projects. Whereas in the first case, however, the money lent to the borrower represented a claim on goods that the public- by curtailing their consumption- had willingly saved up for the purpose of such investment, this time no curtailment of consumption on the side of the public took place: “an act of new ‘investment’ can occur that is independent of any increased voluntary ‘savings’” (Ebeling 2010, 291).
In order to entice new borrowers to take on additional loans, the bank must accommodate these new checking accounts at lower interest rates than otherwise, so as to make marginal projects look profitable. These marginal projects tend, according to Mises to be those that are further removed in time from present consumption, for “the sensitivity of a project’s profitability to the interest rate is directly related to its duration” (Murphy 2015, 252). Projects that require capital to be tied up for a long period of time get an artificial boost when the interest rate is lowered, and this incentivises entrepreneurs to engage in long-term capital intensive investments. The market interest rate, thus, in the Misesian framework, “coordinates production across time” (Woods 2009, 67). Consumer’s decision of how to allocate their spending decision between the present and the future gets reflected in the amount of savings they provide to the community. The relative scarcity/abundance of these savings which arise from people’s present to future consumption ratios, is then communicated to the business community via the interest rate: a high interest rate indicating a low willingness to defer consumption into the future, while a lower one denoting more future-orientedness. Based on this interest rate, entrepreneurs make calculations that guide them to align their inter-temporal production decisions with the inter-temporal consumption preferences of the public.
If an increase in loanable funds however, is not a reflection of people’s higher willingness to save, but the consequence of “circulation credit” emitted by the banks, alignment between savers and investors gets distorted. While entrepreneurs are induced to expand the economy’s capital structure and engage in long-term projects that will bear fruit in the more distant future, consumers have not decreased their levels of current consumption. This discoordination, sets in motion a trajectory whereby the economy is pulled contemporaneously into the direction of more consumption and more investment, an unsustainable path that ultimately has to be reversed (Ritenour 2010, 369–70). “Resource scarcities… eventually turn boom into bust” (Garrison 2001, 72). In Nationaloekonomie Mises (1940, 523) would thus conclude that “What is viewed as bad in an economic downturn are the effects coming into play of the consequences of an artificial boom fuelled by credit expansion.”
The Entrepreneurial Class as a Mistaken Master Builder
The insufficiency of available resources to complete all the long-term projects that entrepreneurs have undertaken manifests itself in an increase in the price of consumer goods relative to those of producer goods, and to the re-establishment of a higher interest rate. These changes turn what were considered profitable endeavours into losing economic propositions. Many businesses shut down, while others scale back production and lay off workers. This is the beginning of the recession. Its source is not the insufficiency of aggregate demand, but the “unsustainable” boom driven by the easy money policy of the banking system, which has misled entrepreneurs to invest in overly ambitious plans and to underinvest in shorter production processes that consumers desired the most. A recession, according to Mises, represents therefore a healthy correction, that pushes businessman to stop their wasteful activities and reallocate their available factors of production in line with the most urgent wants of consumers. A recession, one can say, reflects the reassertion of consumer sovereignty across the structure of production.
To show the nature of the boom as involving Malinvestment, and the role of the recession as a healthy liquidation of past mistakes, Mises uses the example of a master builder as a representative agent of the entire business community, who, in misjudging the amount of resources available at hand, advises an overly ambitious construction plan that cannot be completed. “The whole entrepreneurial class is, as it were, in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder’s fault was not overinvestment, but an inappropriate employment of the means at his disposal” (Mises 1949, 556–57).
Proximate Similarities, Fundamental Differences
In both business cycle theories, a crucial role is played by the banking system. It is the newly created credit on the part of the banker, lent to entrepreneurs, that in both scenarios gives birth to the euphoria of the boom, and ultimately to the inevitable ensuing of a crisis. Furthermore, in both theories, recessions represent healthy readjustment processes that need not be interfered with, in order to guarantee the possibility for future economic development. In Schumpeter’s story, however, economic crises are seen as endemic to capitalism, while for Mises they result from tampering with the market economy.
This fundamental divergence derives from the basis upon which their theories are built. Schumpeter departs from a general-equilibrium framework and attempts from there to account for change. Given the constraints of the circular flow, change, he concludes, can only originate from heroic entrepreneurs who, financed by inflationary bank credit, impose their will on consumers and disturb the underlying market structure. Mises’s theory, on the contrary, is based not on a world of equilibrium (non-action), but in one of disequilibrium (action). Change is there from the start as resourceful entrepreneurs strive, under uncertainty, to adjust production—with the help of money prices—toward the satisfaction of consumer wants. Consumer sovereignty, not innovationism, is for him the fundamental aspect of Capitalism (Knox 2005).
It is true that even the latter employs the concept of the evenly rotating economy— which denotes a self-reproducing economy—but the purpose of this concept is not, as for Schumpeter to represent an underlying reality, but “merely to provide a point of departure for construction of a realistic theory” (Hérbert 1988, 128). What needs explanation is how structural maladjustments between inter-temporal consumer preferences and inter-temporal production processes can occur, and to the extent that the market tends to weed out bad entrepreneurs, business cycles must come from non-market forces. Whereas the introduction of loanable funds unbacked by savings thus represents the only logical way of accounting for capitalist evolution in Schumpeterian economics, according to Mises, it represents a violent distortion of the inherent coordinative character of the market process.
CONCLUSION This paper began with the climate of freedom that pervaded Vienna throughout the second half of the 19th century, and which created the conditions for cultural and intellectual advancement. A case in point was the Austrian School, born from the innovative pen of Carl Menger, whose approach radically differed both from the anti-theoretical positions of the German Historical School, and the quantitative economics of Jevons and Walras. Menger was then succeeded by Böhm-Bawerk and Wieser, who seized upon their teacher’s main contributions. Notwithstanding their reception of his message, these two members of the second generation were different in significant ways, and these differences shaped the main figures of the Third Generation: Mises and Schumpeter.
Trained under Böhm-Bawerk, Mises professed the a priori character of economic theory, the insufficiencies of induction, and the relevance of Economics for disclosing the cause and effect relationships that govern the real world. Schumpeter, on the contrary—who “felt closest to the works of Walras and von Wieser”—employed a positivist methodology, emphasized the quantitative nature of Economics and expressed faith to the general equilibrium model. Their methodological differences, as has been shown, ultimately surface in their respective accounts of why structural fluctuations appear in capitalist economies. Here the points of agreement, are surpassed by their divergences not in number, but in essence. To be sure, as both writers touch on very similar issues: the importance of the banking system and its artificial credit expansion in the boom period; the dynamic role of the entrepreneur in bidding resources from other uses; the inherently readjusting character of recessions and the need for re-equilibration. Attesting the similarity on these points is the fact that Mises himself, in 1931, praised Schumpeter’s book as one of the four top contributions in the German language (McCaffrey 2014).
Notwithstanding its merits, however, according to Mises Schumpeter’s Theory of Economic Development was “a typical product of his equilibrium theory” (Mises 2009, 28). Understanding the insufficiency of static analysis—which had only explained how things worked in a stationary setting—Schumpeter set himself the task of disclosing the dynamics of a changing economy. While the end of his research had changed, the means with which he embarked on such project, however, remained unvaried. Wanting to remain faithful to the model of his “great teacher”—which obliged him to view general-equilibrium as the ordinary state of affairs—he formulated a story that began in a state of rest. Soon, by the union of heroic entrepreneurs and ingenious bankers, this state of rest was disturbed, only to be eventually replaced by a new one. In this story, the boom phase of the business cycle is associated with the initial disturbance, while the struggling to reach a new state of rest is representative of the depression. Development and business cycles are inseparable phenomenon.
In Mises’s theory, capitalist development and business cycles are not inseparable. The latter, in fact, is to be considered as the negation of the former. Basing himself on the theory of action as it manifests in the real world, the fundamental aspect of capitalistic development is not, for him, the introduction of technological innovations and the disruption of equilibrium, but production, on the side of risk bearing entrepreneurs, to meet consumers most urgent desires. The alignment between entrepreneurial speculation and consumer satisfaction is made possible by the price system which, being a reflection of underlying scarcity conditions of goods and services, furnish producers with both the compass and incentive to act economically. While entrepreneurial decisions are forever bound by uncertainty, and therefore always susceptible to failure, the understanding of the market as having in-built mechanisms of adjustment, brought Mises to the conclusion that a cluster of errors can occur only when the price mechanism is tricked by the credit expansion of the banking system, creating a maladjustment between consumer’s time preference and the structure of production.
Bob Murphy gives a quick explanation of the Mises-Hayek theory of the boom-bust cycle, and how Bob used it to forecast the financial crisis in 2008 a year ahead of time. He then explains the significance of an "inverted yield curve," and shows how the Austrians can understand its predictive power much better than Keynesians like Paul Krugman can.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Bob Murphy explains some of the most important points in his new QJAE article on the fractional reserve banking debate. Bob shows why Mises thought any issuance of fiduciary media caused the boom-bust cycle, and he points out a major flaw in George Selgin’s defense of fractional reserve banking.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
ABSTRACT: According to Austrian business cycle theory (ABCT), there is no macroeconomic market failure. Under laissez faire capitalism, with extremely limited or no government, there will be no credit-induced business cycles. However, suppose one part of the world engages in credit expansion, which, according to ABCT creates the business cycle, while another does not. Will the former infect the latter? Or will the latter be impervious to the governmental depredations of the former? We take the position that although the free market society will not remain impervious to the government failure of the interventionists, it will be sheltered from the full impact of the boom-bust cycle. Do the residual malinvestments constitute a market failure? After all, a free market, in this case, is indeed “failing” to bring about the greatest satisfaction of consumer preferences. We deny this claim.
KEYWORDS: business cycle, international relations, Austrian economics, market failure JEL CLASSIFICATION: B53, E32, E58, F33, F44 Walter Block (wblock@loyno.edu) is Harold E. Wirth Professor of Economics at Loyola University, New Orleans. Lucas Engelhardt (lengelha@kent.edu) is Associate Professor of Economics at Kent State University, Stark. Jeffrey Herbener (jmherbener@gcc.edu) is chair of the Department of Economics and Sociology at Grove City College. The authors would like to thank the other members of the faculty at the Mises University of 2015. The oral examination by the faculty of MU students was the catalyst for this paper, although our youngest co-author (Engelhardt, 2004) penned his thoughts much earlier on some of the issues we address in the paper. The authors also gratefully acknowledge the comments offered by participants of the Austrian Economic Research Conference and the International Conference of Prices and Markets on earlier drafts of the paper. Finally, we acknowledge several helpful comments by two anonymous referees. The usual caveats apply: we three authors are solely responsible for all remaining errors of omission and commission.
Quarterly Journal of Austrian Economics 21, no. 4 (Winter 2018) full issue, click here.
Even though various countries have “independent” monetary systems… inflation taking place in any one nation may have—and often does have—repercussions which go beyond that country’s confines…. Thus, even in the absence of an international monetary system, important economic units can transmit the “virus” of inflation to other countries (Heilperin, 1939, p. 164).
I. INTRODUCTION Austrian economists often advocate a free market monetary system—one that operates without credit expansion or monetary inflation. Such a system is advocated because it would provide greater economic stability, as it would eliminate the Mises-Hayek-style credit-induced business cycle. At the same time, it is admittedly unlikely that one could expect the entire world to immediately change from the current fiat, expansionary monetary system to free market money. So, given that most of the world operates on a fiat basis, could a single country protect itself from credit-induced business cycles by adopting a free market money and banking system? Or, would the existence of credit-induced business cycles in the rest of the world continue to have an impact on a country that adopted a free market regime? This paper suggests that credit-induced business cycles would indeed transmit to a country with a free market monetary system, but that the misallocative effects of these business cycles from abroad would be significantly dampened. In short: the adoption of a free market money in a fiat money world is beneficial, even if it does not completely insulate the country that adopts this system from credit-induced business cycles originating elsewhere.
This paper draws from two existing literatures. First, from the literature on international business cycle transmission. Second, we base our analysis on Austrian business cycle theory, which place a strong emphasis on credit-driven distortions in the capital structure and economic calculation.
An extensive literature exists on how business cycles transmit across political boundaries—going at least as far back as the specie-flow mechanism described by David Hume in the 18th century. In examining the transmission of monetary disturbances, neoclassical literature has adopted an expenditure-flow approach in which real production is asserted to move in lockstep with movements in aggregate demand. Within this framework, Frederic Mishkin (1995) summarizes four so-called channels of transmission from monetary disturbances to real production: via interest rates, foreign exchange, asset prices, and credit.
We combine these four channels with Austrian business cycle theory, with its emphases on the capital structure and economic calculation. Following the work pioneered by Carl Menger and Eugen von Böhm-Bawerk, we depict production as a capital structure and changes in production as driven by the profit and loss calculations of entrepreneurs.Capital structure analysis appears in Carl Menger (1976), Eugen von Böhm-Bawerk (1959), Richard Strigl (2000), F. A. Hayek (2008), Ludwig von Mises (1998), Murray Rothbard (2004), Ludwig Lachmann (1978), Roger Garrison (2001), and Jesús Huerta de Soto (2006). Specifically, we postulate a conjectural case of a worldwide division of labor and capital structure constructed, maintained, and improved by entrepreneurs operating private enterprises within an international market economy. This construction permits us to explore the particular manner in which resources will be reallocated and the capital structure altered across the world economy by monetary disturbances arising in one geographical area and transmitted to another.
Neoclassical attempts to overcome the confining character of the basic Keynesian model have been limited to modifications of minor assumptions of the framework, instead of augmenting the expenditure-flow model with the microeconomics of production and investment in the market. By introducing elements of complexity in the basic model, neoclassical economists have sought to generate more robust explanations and predictions. The neoclassical synthesis of the 1950s developed the IS-LM model which grafted onto the basic Keynesian framework limited behavioral assumptions. Within the context of the neoclassical synthesis, Robert Mundell developed his work on the international economy. Mundell (1963) and Marcus Fleming (1962) launched open economy macroeconomics by extending a basic Keynesian macroeconomic model to include international trade. In keeping with its Keynesian framework, the dynamics of the system operate through expenditure flows, which now include net exports along with consumption, investment, and government spending. While such models incorporate the exchange rate along with the interest rate as explanatory factors affecting real production, they still exclude the array of prices of consumer and producer goods and the structure of production. As neoclassical macroeconomics worked toward the new neoclassical synthesis, the extended behavioral assumptions generated more complex macroeconomic models.On the new neoclassical synthesis, see Goodfriend and King (1997). The New Open Economy Macroeconomics (NOEM) began with the work of Obstfeld and Rogoff (1995) who modified the more complex, closed-economy Keynesian models of that period. More recently, the dynamic stochastic general equilibrium models widely used in macroeconomics have become the basis for NOEM. Despite their greater sophistication, NOEM models incorporate neither the interrelated array of prices throughout the economy nor its integrated structure of production. Mainstream economists tend to continue to use their models to analyze the same problems of system dynamics and the consequences of policy variations among countries. We find this approach inadequate for the discovery of the cause-and-effect structure of a changing international economy.
Meanwhile, Austrian macro-theorists have generally considered business cycles within a domestic context. In recent years, several economists working in the Austrian tradition have sought to move the Austrian business cycle into an international context. As a few recent examples: Hoffman and Schnabl (2011) consider the impacts of credit expansion in large “center” economies on smaller “periphery” economies. Cachanosky (2014) extends the Mises-Hayek theory from the original context of the classical gold standard to a world of open economies and fiat currencies, considering both fixed and floating exchange rates in that context. Bilo (2018) places credit-driven business cycles in an international framework, focusing on the coordinating roles of interest rates and exchange rates.
These analyses provide important insights into how Austrian business cycles transmit in the current monetary regime, and, in that way, provide an update to, and expansion of, the work of Mises and Hayek. Our paper builds on the recent literature in three ways: first, drawing from Mishkin (1995), we introduce additional potential channels of transmission to the Austrian analysis. Hoffman and Schnabl (2011) focus primarily on the interest rate channel. Cachanosky (2014) adds exchange rates to the analysis, and Bilo (2018) also focuses on these two channels. We add the asset price channel and credit channel as well. Second, we are explicitly considering a case where one country is operating on a fiat basis while the other is operating on a market-chosen monetary system. Hoffman and Schnabl (2011) and Bilo (2018) do not take a stand on the monetary systems in the countries not currently engaging in credit expansion. In contrast, Hayek (1989) analyzed international aspects of three possible monetary regimes, but assumed that each country adopted a similar policy (commodity, national reserve, or fiat). Similarly, Cachanosky (2014) is quite explicit that the analysis in that paper applies to fiat currencies. Third, we introduce the role of economic calculation, which receives no explicit attention in any of the recent work (though economic calculation certainly underlies the coordination failures described by Bilo (2018)).
In the present paper, we explore a conjectural case not found in the literature, which we call a dichotomous monetary regime. The extant literature postulates a homogeneous monetary regime across the international economy, e.g., fiat money produced by the state in each country. We postulate an international economy consisting of a laissez-faire monetary regime in one area and fiat money in the other. This arrangement permits us to develop a complementary conclusion to the one reached by Hayek. He (1989, p. 4ff) began his analysis, conceptually, with an international commodity money and showed that moving toward a monetary nationalism of fiat currencies generated more monetary volatility, a result counter to the claims of proponents of monetary nationalism. Our analysis, in contrast, demonstrates that the process of beginning with an international system of fiat currencies moving toward monetary decentralization based on a commodity standard leads to superior results for the countries adopting the latter. In the period of transition, a dichotomous monetary regime exists, one sector with market money and the other with a state monetary system. Nor is this case interesting only theoretically; it also has relevance for international monetary reform movements toward a pure market economy. It demonstrates that even unilateral adoption of a commodity money standard in a world economy with fiat currencies will, at least partially, insulate a commodity money country from the effects of monetary inflation and credit expansion arising in the rest of the world.
In section II, we describe the channels of transmission. In section III, we report on the two dimensions of the international structure of capital. In section IV, we review F. A. Hayek’s work on the transmission of monetary disturbances in uniform, international monetary regimes. Section V stipulates the conditions for our analysis and draws the implications from these stipulated conditions. In section VI, we assess the claim of market failure in the laissez-faire sector of the orthogonal monetary regime international economy. We state our conclusions in section VII, along with suggestions for further research.
II. CHANNELS OF TRANSMISSION Mishkin (1995) provides a summary of four channels through which business cycles can transmit internationally from one country to another as a result of expansionary monetary policy, within an expenditure flow framework.
First, the interest rate channel transmits the effects of monetary inflation by lowering interest rates, which increases investment spending, resulting in a stimulus to production. The interest rate channel can operate internationally through capital-funding arbitrage. If monetary inflation in country B pushes down interest rates in B, then some of the additional credit will be arbitraged via international financial markets into country A, reducing interest rates and increasing investment spending there also. Hoffman and Schnabl (2011), Cachanosky (2014), and Bilo (2018) provide similar arguments, and apply this channel to Austrian business cycle theory.
Second, the exchange rate channel operates as monetary inflation in country B devalues B’s currency relative to that of country A. Ceteris paribus, net exports in B rise, stimulating production in B, and in country A net exports decline, suppressing production in A. Cachanosky (2014), and Bilo (2018) apply this argument to the heterogeneous view of capital present in Austrian capital theory.
Third, the asset price channel works via a wealth effect. Monetary inflation in country B increases asset prices in B as interest rates are lowered. Investment and consumption expenditures in country B increase in response and production is stimulated. With world-wide asset markets and international financial markets, the same sequence of effects will occur in country A from monetary inflation in country B. In country A, we can explain the asset price effect on two bases: first, the interest rate effect described above leads country A’s interest rates to fall as country B’s do, which raises the present discounted value of assets paying future cash flows. In addition to this, the wealth effect in B leads some market participants in B to purchase consumer goods, capital goods, and financial assets in A. So, this international arbitrage simultaneously affects interest rates and asset prices. Thanks to the increased value of domestic assets, people in country B will also increase their investment and consumption expenditures.
Fourth, the credit channel transmits the effects of monetary inflation in country B through a rise in bank reserves and consequently bank lending in B. The additional credit finances more investment and consumption which, in turn, stimulates production in country B. With an international system of banking, the central bank purchase of securities in B can expand bank reserves not only in B but also in A, leading to more investment and consumption in A with the concomitant increase in production in country A. This channel works in concert with the interest rate channel, amplifying the effects. The interest rate channel focuses on the direct impacts of the interest rate on investment decisions, while the credit channel focuses on the impacts of the availability of credit. When monetary policy is expanding credit, both effects typically happen hand-in-hand.
III. INTERNATIONAL CAPITAL STRUCTURE In contrast to other business cycle theories, Austrian business cycle theory placed the capital structure (as described by Menger [1976] and Böhm-Bawerk [1959]) at the very center of the analysis. Böhm-Bawerk’s framework has been further expanded by later Austrians, especially Hayek (1966), Rothbard (2004), and Garrison (2001). Garrison (2001) suggests that Austrian business cycle theory can be thought of as the “capital-based” explanation for the business cycle.
In the Austrian view, capital is best thought of as concrete capital goods that are somewhat specific in their use in the structure of production. Unlike most other theories, which either omit capital almost entirely or which simplify capital to a single homogeneous variable,All too often perfunctorily depicted as “k” and then almost ignored. in the Austrian tradition, capital is thought of as being arranged based on its relationship to its ultimate purpose: transforming the original factors of labor and land into specific, final consumer goods.
The international capital structure brings together two different dimensions in terms of which entrepreneurs must economize: time and space. Each is open to mal-investments, and may potentially be affected by monetary policy.
First, capital has a time dimension. All action is geared toward the future fulfillment of some want—or “consumption.” However, immediate want-fulfillment is typically not possible using only the original factors of production, or is less productive of satisfaction than somewhat delayed round-about methods of want-fulfillment. We can arrange capital based on how far removed from consumption it is. Consumption goods (or goods of the “first order”) are directly useful in satisfying human wants. Capital goods require some period of time—typically because of the need for some physical transformation—before they will be capable of satisfying a direct want. (As an example of the simplest case: wine must have time to age for it to attain the greatest value for consumers.) Capital goods then can be divided between lower order capital goods—which are closer to consumption and higher order capital goods—which are further removed from consumption. For example: finished products in transit to retail outlets are very low order capital goods. Raw, unprocessed iron still in the ground is a higher order capital good.Garrison, 2001 speaks of earlier (higher) and later (lower) capital goods; Barnett and Block, 2006, in terms of interest elasticities.
Second, capital is arranged in space. Resources and consumers are not evenly distributed across the terrain, and so capital tends to be geographically concentrated based on ensuring access to resources by consumers. While we are not particularly interested in the spatial allocation of capital in and of itself, we are concerned with the fact that spatial allocation leads capital to be placed in different currency areas. Because of the spatial distance that often separates resources and consumers (as well as complementary capital goods!), interregional trade is quite common—and, at times, the regions involved are located in countries that use different currencies. The spatial dimension can also carry with it a financial component. Investors are generally not constrained to only invest in local capital. Rather, through the use of financial assets like stocks, investors can invest in physical capital in a country that uses a different currency than their own. So, while physical capital is more location-bound, the ownership of that physical capital is typically not.
When making investments, entrepreneurs consider these two dimensions of time and space. As in all profit-oriented decision-making, businessmen engage in economic calculation to determine the best temporal and spatial location of capital investments. In their calculations, entrepreneurs will consider the interest rate—which impacts their decisions regarding the time axis, and will also consider currency exchange rates (and especially expected changes in those rates)—which will impact their decisions regarding in which country to locate physical capital or in which nation to invest in financial assets. Since monetary policy can affect both interest and exchange rates, it has the potential to alter entrepreneurs’ economic calculations—and therefore decisions—along both the time and space dimensions.The Austrian business cycle literature—from Mises (1953) through de Soto (2006)—has emphasized the role of interest rates on the time dimension. The new international Austrian business cycle literature has added a consideration of exchange rates, as seen in Cachanosky (2014) and Bilo (2018).
IV. UNIFORM INTERNATIONAL MONETARY REGIMES In his book, Monetary Nationalism and International Stability, Hayek (1989) compared and contrasted the inter-connectedness of the economies in various countries under three different monetary regimes: a homogeneous commodity standard; a national reserve system (e.g., the classical gold standard); and independent national currencies (e.g., fiat monies during the decade before the Bretton Woods system).Milton Friedman (1953) also examines three international monetary regimes: fixed, flexible, and pegged exchange rates. The first corresponds to Hayek’s National Reserve System and the second to his National Fiat Monies (with Independent National Currencies). Hayek does not consider Friedman’s third case of pegged exchange rates, the prominent example of which, Bretton Woods, occurred after Hayek’s book was published. The case Hayek favored, a Homogenous Commodity Standard, is conspicuously absent from Friedman’s analysis.
In a Homogeneous Commodity Standard, there are no monetary disturbances. Neither monetary inflation (deflation) nor credit expansion (contraction) is possible. Instead, the production of money is regulated by profit and loss in the same manner as that of any other good. If demand for money increased (decreased) relative to other goods, then the revenue of money production would rise (fall) relative to its costs of production. In response, entrepreneurs would expand (contract) production of money which would lower (raise) the price of their output and raise (lower) the price of their inputs eventually making even further expansion (contraction) of output unprofitable. Increased (decreased) production of money would be balanced by diminished (augmented) production of other goods. Moreover, the calculation of profit and loss for every item in every location would be in the same monetary unit, allowing entrepreneurs to make direct, worldwide comparisons to determine the most economizing use of resources. Likewise, entrepreneurs would be able to directly compare their appraisements of assets in different lines of investment across the entire worldwide capital structure. All production and investment decisions would survive only by passing the market tests of economic calculation. The result of free enterprise and free trade within such a monetary regime would be the greatest degree of satisfaction of consumer preferences via the most extensive development of the division of labor and of capital accumulation. Goods, including money, would move across borders from territories in which they had lower value into those in which they had higher value.
In a Homogeneous Commodity Standard, Hayek (1989, pp. 17–25) showed that the movement of money from one country to another would occur in response to differences in money demand. As would be the case for any good, entrepreneurs earn profit by moving money from the hands of those who value it less and into the hands of those who value it more. Far from disruptive of production processes, such movements of money, as with any other good, adjust the supply that has been produced to accommodate people’s preferences. Trade, then, augments the division of labor, increasing the efficiency with which resources satisfy people’s preferences. In this system, international trade is similar to domestic trade. In the latter, a change in demand leads to an alteration in the distribution of goods according to the consumers’ new preferences. The same occurs with international trade under this system, with the monetary system causing no specifically monetary disruption to the adjustment process.
While there is a common commodity money used in every country in a National Reserve System, it serves as a reserve for each country’s currency which consists of fiduciary media issued by each government or its privileged banks or both. Production of money itself, in such a system, can still be regulated by profit and loss since it entails production costs rendered by the market. Moreover, by defining its currency in terms of commodity money, each country fixes the ratio between its own currency and that of every other nation. Without the issue of fiduciary media in each country, this arrangement would not differ in operation from the Homogeneous Commodity Standard.
The issue of fiduciary media, however, is not regulated by profit and loss, but rather always generates seigniorage for every amount issued up to the point at which the currency is destroyed in hyperinflation.The term seigniorage has been used to describe several distinct phenomena. For examples, see Neuman (1992) and Rolnick (1997). We will use the term seigniorage to refer to the net income generated by exercising a legal privilege in the production of money and money substitutes. Because it is not regulated by profit and loss, generating seigniorage introduces inefficiency into the operation of the market economy. And when privileged banks issue fiduciary media via credit expansion, it not only is indefinitely profitable to the point of hyperinflation, but sets in motion the boom-bust cycle with its attendant malinvestments of capital investment and misallocations of resources.On Austrian business cycle theory (ABCT), see Mises (1953, 1998), Hayek (2008), and de Soto (2006). Because its issue is not constrained by demand for money relative to demand for other goods, any issue of fiduciary media introduces an alien element into the market economy. We can call this alien element monetary inflation (deflation) when fiduciary media increases (decreases). In addition to the disturbances to the economy in each country from monetary inflation and deflation, the disparate issue of fiduciary media in each nation can cause monetary disturbances in one country to be transmitted to another. Monetary inflation and credit expansion in one jurisdiction sets in motion a domestic boom. As prices rise domestically and the exchange rate stays anchored to the underlying commodity price ratio, the purchasing power of the currency becomes higher elsewhere. Imports increase relative to exports. When foreigners obtain the currency of the inflationary country, they redeem it for the commodity reserve and it moves from the inflationary country to others. The outflow of commodity reserve, then, collapses the boom in the inflationary country and the inflow of commodity reserve abroad stimulates a boom there.
As Hayek (1989, pp. 25–34) argued, these twin effects in the supply of money are not, however, identical to those brought about by changes in the demand for money in the two countries. The collapse in one area does not translate into expansion in the other area because the movement of money does not occur to satisfy differences in money demand through voluntary exchange. Instead, the adjustment falls upon a different set of people apart from those with differing money demands. Money moves into the hands of investors in the boom area, not those who desire to hold more money. If the exchange rate does not adjust downward to restore purchasing power parity of the inflationary country’s currency across other countries, then profit can be earned by moving the commodity reserve in the inflationary country to other countries, even though this does not satisfy a greater demand for money in the latter relative to the former.
The system of National Fiat Monies consists of government-directed production of currency which serves both as money and as reserve for fiduciary media issued by commercial banks. The government directs monetary inflation by printing additional currency and thereby, increasing bank reserves upon which these firms issue more fiduciary media. In such a system, neither money production nor the movement of money is brought forth exclusively by differing extents of money demand relative to other goods among people in different places. Without any change in people’s demand for money schedules (and hence, no demand-induced increase in money’s purchasing power to justify more production of money), the government and commercial banks can generate monetary inflation by expanding bank reserves and thus the accompanying credit expansion. Even though this activity is not regulated by profit and loss, it does generate seigniorage for the government and commercial banks. As the purchasing power of money is driven downward by its increased supply and interest rates are suppressed by the expansion of credit, people respond by increasing the quantity they demand of both money and credit. The process over time of the lowering of money’s purchasing power will be uneven across persons, places, and times because the new money produced will come into the hands of particular people in particular places sooner and other people in other places later. During this process, money will tend to be moving out of the hands of people in places for which its purchasing power has already been lowered and into the hands of people in places for which its purchasing power has not yet been lowered. Because the production of money is not economizing and therefore, leads to artificial volatility in real production processes, the movement of money from the earlier recipients in some places to the later recipients in other places is not economizing overall either. Instead it transmits artificial volatility, bringing more people and places under its effects.
With National Fiat Monies there are two variations. The first, which is the case Hayek examined, may be called Independent National Currencies. In this system, none of the currencies of the various countries serves as a reserve for any other currency. There is no integration of currencies themselves across the various national borders. Changing conditions of demand for and supply of each currency adapt to demand and supply changes of every other currency through movement in exchange rates. Monetary inflation and credit expansion in one country that lowers the purchasing power of its currency domestically will not result in the movement of its currency to less-inflationary countries. Instead, the exchange rate of its currency will devalue relative to the currency of less-inflationary regions. If the exchange rate devalues before the purchasing power of money declines (rises) domestically, the monetary inflation and credit expansion will increase net exports (net imports) in the more-inflationary (less-inflationary) country and thereby, impose changes in real production processes in less-inflationary countries.
As Hayek (1989, pp. 35–53) pointed out, then, in a regime of Independent National Currencies, the movement of money cannot perform its economizing function at all. He argued that in such a system, actual imbalances between money demands among countries will be dealt with politically. Monetary policy in each country will result in fiduciary expansion and contraction, which brings with it cyclical volatility. This is the very consequence that monetary nationalists claimed to avoid with their program of monetary nationalism. In light of these consequences, Hayek rejected the regime of National Fiat Monies in favor of a worldwide Homogeneous Commodity Standard.
The second variant of a system of National Fiat Monies might be called an International Reserve System. Bretton Woods after the Second World War serves as an example. The currency of one country serves as reserve for those of other countries. Each government pegs its exchange rate with each of the currencies of every other government and buys and sells currencies in foreign exchange markets when necessary to maintain the pegged exchange rates. Monetary inflation and credit expansion of the reserve currency will put pressure on it to devalue against other currencies. Other governments respond with monetary inflation and credit expansion of their currencies in an effort to maintain the pegged exchange rates. As Hayek said about the case of Independent National Currencies, in this case as well neither money production nor its movement can perform the economizing function that entrepreneurs attain in the production and movement of commodity money and other goods. Unlike the case of Independent National Currencies, however, devaluation that would have occurred as a consequence of sufficient monetary inflation of one currency relative to another will be preempted by monetary inflation of the other currency. Instead of real production processes in the second country being affected solely by the rise in its net imports, it will suffer its own domestic boom from its domestic monetary inflation and credit expansion.
In summary, applying Hayek’s analysis demonstrates: (1) both the production and movement of commodity money in a Homogenous Commodity Standard is economizing; (2) the production of commodity money can be economizing under the National Reserve System, but the movement of commodity money set in motion by fiduciary issue in one country generates a boom in foreign lands; (3) the production of fiat money cannot be economizing in a regime of National Fiat Monies; instead there will be monetary inflation and either (3a) the movement of the reserve currency from its country of origin into other countries as a result of monetary inflation will generate booms across them (the sub-case of an International Reserve System) or (3b) the impact of monetary inflation in one country on the money stock of other countries will be determined by politics since the movement of money cannot perform its economizing function (the sub-case of Independent Fiat Currencies).
V. THE DICHOTOMOUS MONETARY REGIME All the cases that Hayek considered involved a “uniform” international monetary system. That is, he considered examples in which all countries adopted the same type of system. In contrast, we examine a dichotomous international monetary system, in which two countries have adopted different monetary systems. Country A has a market-based commodity money, where the production of money is decided by entrepreneurs engaged in economic calculation of profit and loss, and banks do not issue fiduciary media.With this structure, credit-induced business cycles would not occur. See Rothbard, 1962a, 1962b, 1963a, 1963b, 1969, 1983, 1988. Country B has a fiat money and regulates the issue of fiduciary media by commercial banks, but is, otherwise, a free market economy.Austrian business cycle theory describes how this structure leads to business cycles. Keynesianism in its various forms drives this process onward. For critics of Keynesianism, see North, 2013; Block, 1999; Rothbard, 2002; Wapshott, 2012; Cochran and Glahe, 1999; Dempster, 1999; Garrison, 1985, 1992, 2010; Hoppe, 1992; Hutt, 1979; Rostan, 2010; Rothbard, 1992; Skousen, 1992; Hammond, 2012; Ritenour, 2000, Murphy, 2008; Anderson, 2009. Our goal is to analyze the precise manner in which monetary disturbances are transmitted from a fiat money country like Country B into a commodity money country such as Country A, a case Hayek did not study. Given the precise manner of transmission in such an example, we consider a system of “private-enterprise protection” to limit the malinvestments of capital and misallocations of resources in A in response to monetary inflation and credit expansion in B.Our literature search included the following, none of whom addressed this possibility, even though all of them write widely and deeply about international economics and macroeconomics: Haberler (1936), Heilperin (1939), Machlup (1943), Roepke (1959), Viner (1937).
Because of international trade linkages, people in Country A would have a limited demand to hold the money of Country B, while those in Country B money would have a limited demand to hold Country A’s money. So, international transactions could occur in either currency, allowing for an exchange rate to be established between these currencies (Mises, 1953).
Unlike either the National Reserve System or the National Fiat Currency system with International Reserve Currency, monetary inflation in B does not directly affect the supply of money in A. The money of B cannot become a part of A’s money stock. Instead, monetary inflation in B would lead to an appreciation of A’s money against that of B as traders in B increase their demand to hold A’s money. Even if this appreciation of A’s money against B’s leads to an expansion of money production in A, the additional production would itself be regulated by profit and loss. With economizing production of money reserve and no issue of fiduciary media, there can be no domestic credit expansion in A. The credit channel’s impact is minimal.
Shielded from the possibility of generating its own domestic monetary inflation and credit expansion in concert with the rest of the world, business cycles emanating from B can be transmitted to A by one or more of the other three channels: exchange rates, interest rates, and asset prices. Within the framework of the international division of labor and worldwide capital structure, however, these channels operate, not through expenditure flows themselves but, via the patterns of trade of particular goods and services. As well, resource and capital capacity used in their production according to the economizing position of production and investment that A occupies in the international economy play a role.The effects on the prices and production of particular goods during monetary inflation are attributed to Richard Cantillon (1931). On his contribution to ABCT, see Hülsmann (2001), Rothbard (1995), and Thornton (2006).
Consider first the exchange rate channel. Monetary inflation and credit expansion in B distorts economic calculation, generating a boom in B. The money relation in A, however, is only minimally affected since B’s currency is held only to a very limited extent in A’s economy. Instead, the pending imbalance in the purchasing power of B’s currency in B compared to A will lead to a devaluation of B’s currency relative to A’s. Entrepreneurs in A, therefore, are in a better position than their counterparts in B to limit the misallocation of resources and malinvestment of capital. Why? This is because the supply of A’s commodity money would only increase in response to the increased demand for that money, leaving the purchasing power of A’s money relatively stable. Traditional profit and loss accounting is backward-looking. And, generally speaking, there is a temporal gap between when costs are incurred in the purchase of resources and when the revenues from selling the resulting product are earned. If there is a significant change in the money relation—specifically, if the purchasing power of money falls significantly over time, then accounting profit will be overstated. Economic calculation, though forward-looking, is informed by past experience, and when that experience is misrepresented, economic calculation becomes less reliable. Because of the relative stability of the money relation in A, economic calculation in A is more reliable as a guide to production and investment decisions than it is in B. Unless devaluation of country B’s currency against that of country A occurs synchronously with the decline in the purchasing power of B’s currency domestically, however, the balance of trade will be distorted between the two countries. In the typical case, the devaluation of B’s currency occurs sooner than domestic reduction in the purchasing power of B’s currency causing net exports (imports) in B (A) to rise. This effect is then reversed as the domestic purchasing power of B’s currency falls to parity with its purchasing power in A, given the already devalued exchange rate. The particular goods affected will be those in line with the latent comparative advantages of the two countries.
One would expect B’s exports to increase in two ways: first, some goods that B would otherwise consume domestically may now be sent abroad, as the alteration in exchange rates makes exporting look relatively more attractive. Assuming that nominal prices remain nearly the same at first, then the depreciation in B’s currency will raise the B-currency price that businesses can receive from exporting simply because a single unit of A’s currency has a higher B currency value than previously. Second, non-specific resources initially placed in less export-oriented industries may move into those that are more export-oriented, for similar reasons. This point is emphasized in Cachanosky (2014). Changes in production and investment in the two countries will move along the lines of the worldwide capital structure. Because the exchange rate channel sets in motion a self-reversing effect on profit in particular lines, the effect on production in A depends on the anticipations of entrepreneurs in those lines of production. Just as entrepreneurs in particular lines of production can anticipateWagner (1999) argues that businessmen will tend to anticipate the machinations of the Fed which would otherwise create the Austrian Business Cycle, and thus the ABCT is incorrect. For an alternative view, see Block (2001). other types of cyclical variations in demand for their products, they may be able to keep malinvestments of capital and misallocations of resources within manageable limits. Although the exchange rate channel is not entirely closed, its flow can be mitigated by entrepreneurship exercised in a free market economy.
Consider next the effect of movements of interest rates. As described by Hoffman and Schnabl (2011), credit expansion in B will suppress interest rates in credit markets in that nation. Arbitrage opportunities would arise for financiers who shift investment away from credit markets in B into those in A. As with the exchange rate channel, however, interest rates will operate through investment in particular lines of production across the capital structure according to latent comparative advantage in A. These investments will increase the prices of assets along particular lines of the capital structure in country A. Unlike the asset channel that operates from monetary inflation and credit expansion within B, however, in A the increased prices of assets will be countered by the decreased prices of other goods. Because any rise in demand for A’s commodity money in B will be met by money producers increasing the supply of that money, and there is no other reason for either the demand for A’s money relative to other goods or the supply of A’s money to alter, the overall purchasing power will change little. Only minimal overall wealth effects will occur. The asset price channel’s impact is minimal.As income is reallocated from asset price inflation, distributional effects on wealth may occur. On wealth effects during the business cycle, see Salerno (2012).
Even though the asset price channel is weak, prices of particular assets in country A will rise along the lines of the boom generated in country B. The extent and timing of asset price inflation will depend upon the anticipations of entrepreneurs who are appraising the realized market price of assets in the future. Alongside these entrepreneurs are investors in financial markets, including foreign exchange, who are, likewise, forming anticipations of the realized market price of future financial assets and currencies. Given an economizing distribution of entrepreneurial acumen across the different lines of entrepreneurial activity in production and investment, the asset price inflation in country B and the devaluation of its currency against that of country A should reflect a similar accuracy relative to the relevant realized market prices. Currency devaluation and asset price inflation set in motion by a given episode of monetary inflation and credit expansion should be roughly synchronous or, at least, more synchronous than currency devaluation and the reduction in its domestic purchasing power. The rise in asset prices in region B, however, will still generate some profit for investors who shift their purchases to A. The extent of the resulting arbitrage, however, will be blunted by devaluation of country B’s currency. The more synchronous the devaluation is with the rise in asset prices, the less monetary incentive there will be for such arbitrage. To some degree, then, the interest rate channel and exchange rate channel generate offsetting effects on A.
Dornbusch (1976) speaks to the question of timing and how effects on interest rates and exchange rates interrelate. Assuming uncovered interest parity (that is to say: assuming international financial arbitrage), if the interest rates in country A do not immediately and fully adjust when interest rates in country B do, then the exchange rate will “overshoot.” Since interest rates are lower in B than in A, the only way for this to be consistent with arbitrage is if B’s currency depreciates immediately and severely—so much so that the currency is expected to appreciate over time, to make up for the difference in interest rates. If this is not the case, then investors will continue shifting investments from B to A, which increases the interest rate in B, decreases it in A, and leads to further depreciation of B’s currency. This implies that the strength of the interest rate effect and the power of the exchange rate effect are inversely related. If interest rate effects are large, then little overshooting will happen—so the exchange rate effect will be somewhat smaller. If interest rate effects are small, then significant overshooting will occur, resulting in exchange rate effects greater than otherwise would have occurred.
Whatever the residual extent of asset price inflation remains in A, its effect on the broader array of economic activity will depend upon the response of entrepreneurs in the lines of production experiencing asset price inflation. If they resist expanding production, then other lines of production will likewise experience neither significant misallocation of resources nor malinvestment of capital. Whether or not entrepreneurs can provide “private protection” against infection from business cycles generated externally, and if so, in what way they can do this, will be taken up in the next section.
In preparation to addressing this issue, let us summarize the manner in which the virus attempts to spread from B to A. Monetary inflation and credit expansion in country B will generate a boom in B. The money of country A, however, cannot be inflated. Neither can credit in A be expanded. The virus cannot spread significantly through the credit channel. The malinvestment of capital and misallocation of resources in B will be driven by suppressed interest rates and asset price inflation in B and devaluation of its currency against that of A. Investors in B, who wish to earn the now higher interest rates in A, may do so by purchasing assets and claims to assets in A, which further suppresses the value of B’s currency in comparison to A’s. Although the asset price inflation in B can have a wealth effect, resulting in further malinvestment and misallocation in B, since the purchasing power of money changes very little in A, only a minimal wealth effect occurs there from the asset price inflation in A. The virus cannot spread significantly through the asset price channel. To the extent that devaluation occurs synchronously with the lowering of the domestic purchasing power of B’s currency, the balance of trade between A and B will not change and the asset price inflation infecting A will be limited to the difference between the asset price inflation in B and the decline in purchasing power of B’s currency. In the typical case, in which devaluation occurs prior to the lowering of the domestic purchasing power of B’s currency and synchronously with asset price inflation in B, net exports (imports) in region B (A) will rise along with the increased demand for assets in area A by investors in B. These effects would then be reversed as the purchasing power of B’s currency domestically fell into line with its devalued purchasing power internationally. On net, then, the exchange rate and interest rate channels have offsetting effects on A. In short, the virus of monetary inflation and credit expansion in B does indeed infect country A through changes in the prices of particular goods produced in A along the lines of its comparative advantage. Contrary to the cases of uniform international monetary regimes, in which a boom in one country can lead to a general boom in the other, the transmission of monetary disturbances from fiat money countries into a commodity money country are strictly limited and readily identifiable.
VI. DOES LAISSEZ FAIRE FAIL? Although a commodity money economy would be largely insulated from monetary disturbances generated in fiat money economies, Cantillon effects would occur from the residual asset price inflation in the commodity money country. The consequences for real production processes, however, depend on entrepreneurial anticipations. Entrepreneurs with superior foresight in the lines of production experiencing Cantillon effects will be less prone to malinvest capital and misallocate resources.On the spectrum of entrepreneurial foresight, see Engelhardt (2012). They will assess more accurately the extent of asset price inflation and exhibit proper restraint in expanding capital capacity and resource use in production during the boom so as to avoid the losses during the bust. By cutting off the spread of rising entrepreneurial demand for resources and capital capacity at the source, the malinvestment and misallocations associated with the boom-bust cycle can be contained within a narrow scope in country A. Moreover, during the course of the boom-bust cycle, resources and capital capacity tend to move out of the hands of the less insightful and into the hands of those more able to anticipate the future course of events. The less insightful entrepreneurs malinvest capital capacity during the boom and liquidate during the bust. The more insightful ones, by restraining from malinvestment during the boom, put themselves in a position to acquire capital capacity cheaply as the less insightful entrepreneurs liquidate their assets during the bust.John D. Rockefeller’s acquisition of oil-refining capacity during the volatility of the 1870s provides an example of the process. See DiLorenzo (2005, pp. 121–130).
This market process of transferring command over resources and capital capacity away from less insightful and toward more insightful entrepreneurs could be institutionalized into a system of “private enterprise protection.”On Rockefeller’s use of the institution of the trust, see Folsom (2004, pp. 88-89). But, here, “protectionism” would take on a very different meaning than that usually accorded to this policy. Entrepreneurs in A would be the agents offering protection to others from the losses of the boom started by B. In contrast with bureaucrats who rely on the ability of the state to punish those who do not comply with regulations, entrepreneurs persuade others to join them in their ventures by finding and offering them mutually advantageous terms for their cooperation. In this case, they would offer protection by persuading others to join them in sustainable lines of production and to avoid the harm to those who might otherwise succumb to the temptation to participate in the boom. Entrepreneurs could form voluntary trade associations to increase the incentives to refrain from short-term gains so as to avoid malinvestments. Voluntary unions among workers could reinforce the entrepreneurs’ decisions to avoid participation in B’s boom.Voluntary associations have a long and fruitful role in American life, see Bradley (1965), Dekker and Broek (1998), Gamm and Putnam (1999), Merton (1957), Olasky (1992), de Tocqueville (2003 [1835]) During the boom, entrepreneurs who refrain from increasing production and expanding capital capacity, can still earn profit from higher output prices and equity from the asset price inflation. By forestalling misallocation of resources and malinvestment of capital investment, they can also largely avoid the losses and consequent liquidations of the bust. And although economic calculation is made more difficult by credit expansion elsewhere, movements in foreign exchange rates between the inflated monies and the commodity money provide information that entrepreneurs can use to aid economic calculation which would not be available in absence of at least one country using commodity money. Entrepreneurs have a firmer basis on which to form anticipations of the lines of the boom that might tempt residents of country A into making malinvestments of their capital and misallocations of their resources. Adherence to a free market regime of commodity money would be critical for entrepreneurs to sharpen their anticipations to judge between the lines of production and investment that will prove to be sustainable and those that will not.
Even accounting for “private protection” from the ill effects of monetary inflation and credit expansion generated externally, some residual effects of the boom-bust will remain in the laissez faire territory. The final issue, then, is whether or not the residual misallocation of resources and malinvestment of capital investment occurring in A constitutes a market failure.
The main “players” in the market failure literature are monopoly, externalities, public goods, and informational asymmetries.There are literally dozens, scores, maybe even hundreds of others. Here are some of the critiques of this material: Anderson, 1998; Barnett, et. al, 2005; Block, 2002; Callahan, 2000; Cowen, 1988; DiLorenzo, 2011; Guillory, 2005; Higgs, 1995; Hoppe, 2003; MacKenzie, 2002; Rothbard, 1985; Simpson, 2005; Tucker, 1989; Westley, 2002; Woods, 2009a, 2009b. The question now arises: does the fact that economic “infection” can indeed infect economy A constitute a market failure? We deny that this is the case. Why? It is simple. It is not market failure that undermines the economy of A. Rather, it is the government failure of B that leads to this result.Contrary to the tendency among neoclassical economists to see market failures everywhere, however, we maintain the Austrian view on this matter that there is no such thing as market failure.
Even with the success of voluntary associations to moderate the malinvestments and misallocations arising from Cantillon effects, entrepreneurial errors will occur in A. Some residual malinvestments and misallocations will remain. We agree with Hayek that a country whose economy is an integral part of the world’s cannot be entirely isolated from inefficiencies emanating outside its borders. However, what impairs efficient production in country A is not a market phenomenon but rather one of government intervention in the economy in B, in this case. It is a general conclusion of economic theory that entrepreneurs economize on the use of resources for consumers as best they can in the face of barriers established by government intervention. The reaction by entrepreneurs to government obstacles result in the secondary effects that Mises (1998) demonstrated lead to the tendency for government interventions to accumulate. If the overall result of government intervention and the ensuing entrepreneurial reaction is sub-par compared to the laissez faire starting point, the fault lies with the government in B, not the market, in A.For example, the unemployment of the least productive workers under an effective minimum wage is not caused by the inability or unwillingness of free enterprise to employ such workers absent the legally imposed wage. Instead, the blame rests with the state.
A similar claim can be made about monetary inflation and credit expansion within a given country. It is not a market failure that entrepreneurs in A, striving to economize anew in the face of a B central bank driven credit expansion malinvest capital and misallocate resources. The former are, to the contrary, economizing as best they can, given the barriers to doing so instituted by B’s central bank policy. Because having a money independent of the inflationary and expansionary process of the central bank would allow them to economize even more fully, entrepreneurs, if given the freedom to chooseMilton Friedman (1990) argues in favor of being “free to choose.” Yet, he was a bitter opponent of the gold standard, something “chosen” by the marketplace, whenever economic actors were, you guessed it, free to choose. See on this Rothbard (2002); Block (1999). would establish their own sound money system to insulate their operations somewhat from the ill-effects of expansionary monetary policy. One of the key insights of this paper is that, at times, the blame does not rest on the government of the country that feels the ill effects, A in this case. In some circumstances, one must be willing to look abroad to find the original government failure.The South Park Movie featured a song called “Blame Canada.” We adopt this as our own, only we substitute “Blame B.” See on this: https://www.youtube.com/watch?v=bOR38552MJA
Assume that areas C and D both have a policy of total free trade on a unilateral basis. Whereupon D suddenly imposes protectionist measures on imports from C. Will the economy of C be negatively impacted by this unwise measure? Of course it will be. Specialization and the division of labor will no longer be as thorough and all-encompassing as they once were, before protectionism was introduced by D. Would we then acknowledge that “market failure” had overcome C? Of course not. Matters would be clear. We would maintain, instead, that the reason for C’s economic plight had nothing to do with free markets. Rather, we would lay the blame at the door of D, the originator of tariffs and other interferences with full free trade. In like manner, we arrive at the same conclusion for A and B, and the monetary inflation and credit expansion of the latter. Both of these were examples of government failure, not market failure.
Just as unilateral free trade results in the most economizing use of resources for a country adopting it within an international economy of protectionism in other countries, unilateral movement to commodity money will insulate a country as much as possible within an international economy of fiat money inflation and credit expansion. Such monetary reform improves the economizing operation of the market economy within the country that adopts it.
VII. CONCLUSIONS AND SUGGESTIONS FOR FURTHER RESEARCH Stated very briefly, we conclude that economic “infection” is indeed possible. A, despite its market-based commodity money, can still “catch” the disease of the Austrian business cycle from B. However, A will be less susceptible to the spread of this sickness than would otherwise be the case. And, this does not constitute any “market failure.” Rather, this is yet another example of government failure.
Before we move to consider directions for future research, we should consider one question that our analysis has assumed away: why don’t the two countries in question use the same money? We have built an argument—centered on the reliability of economic calculation—for why entrepreneurs would prefer a commodity money without credit expansion. So, it is no mystery why Country A limits its use of Country B’s money. But, why wouldn’t the entrepreneurs in B simply begin using A’s money? There are two answers. First, we note that, in the short run, a particular money experiences significant network effects. If most of my trade relations are with those who use B’s fiat money, then a market actor would likely hold B’s money in his portfolio and would probably keep financial records in B’s currency. In our analysis we consider a time frame in which Country B simply has not yet adopted Country A’s money. Another possibility is that Country B’s fiat money may be supported by interventions such as legal tender laws, which provide a domestic advantage to using B’s currency which would not apply to A.
What are our suggestions for further research?Unhappily, the answers to these research proposals are beyond the scope of the present paper. One possibility is that we pursue evidence of the insulating effect of sounder money. We recommend for all those interested in pursuing it, an analysis of the severity of the boom-bust across different countries with varying degrees of expansionary monetary policy during the recent boom-bust cycle. For example, Zimbabwe, Argentina and Venezuela would be at one end of this spectrum, the U.S. would occupy a position somewhere in the middle of it, and Switzerland would be located at the other end of the spectrum.
Another possibility would be to consider just one country, say Switzerland, which had a floating currency against the Euro before 2011 and a pegged currency from 2011 to early 2015. Under which system did Swiss entrepreneurs do better, ceteris paribus? E.g., under which regime was the ABC more powerful? Cachanosky (2014) provides a good resource for those considering empirical work in relating Austrian business cycles to exchange rate policy regimes.Other empirical studies of ABCT include the following: Bisman and Mougeot, 2009; Butos, 1993; Carilli and Dempster, 2008; Cochran, Yetter and Glahe, 2004; Cochran, 2011; Gallaway and Vedder, 1992; Hughes, 1997; Keeler, 2001; Montgomery, 2006; Mulligan, 2002, 2005, 2006; Murphy, 2009; Murphy, Barnett and Block, 2010, 2012; Powell, 2002; Wainhouse, 1984; Young, 2005.
A third suggestion is to reconsider the experience of those countries that maintained the gold standard during the Great Depression relative to those that abandoned it. The counterclaim that countries that left the gold standard earlier recovered faster than those that left later, may be, in turn, offset by the fact that nations less integrated into the U.S. economy, like Sweden, suffered less during the depression than those more integrated, for example Canada.On France during the Great Depression, see Irwin (2012). In short: the present paper suggests that assuming a strong connection between the domestic monetary system and business cycles, without consideration for international impacts, can lead to misleading conclusions.
Our hope is that this paper provides a theoretical grounding for those looking to do this historical work, and an encouragement to those who do it to look at the impacts of the international monetary system on national economies, since, in some cases, solving the mystery of poor economic performance in a generally free market economy requires looking over the border.
F.A. Hayek (1899–1992) was the most important representative of the “fourth generation” of the Austrian school of economics and the only one so far to receive the Nobel Prize. His many contributions are highlighted by Peter Klein.
Hayek considered himself a socialist until he read Mises's Socialism, where Mises argued that prices and private property are a requirement of economic calculation. He attended Mises’s private seminar along with other top young economists and went on to build upon Mises’s monetary theory. He developed an explanation of business cycles brought on by bank credit expansion encouraging malinvestments in capital.
The Who Is? podcast is available on iTunes, Google Play, Stitcher, Soundcloud, and via RSS.
"Higher order" industries like manufacturing and mining are particularly sensitive to changes in interest rates. And it doesn't look like anything's different this time around.
Original article: British Manufacturing Slumps as Bank of England Raises Interest Rates
From Section 2: "And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years." This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
ABSTRACT: New product R&D, which precedes post-launch production, is a three-stage process. First comes idea prospecting, which leads to working prototypes. Second comes productization—the conversion of working prototypes into manufacturable products with reasonable prospects of being profitable. Thirdly, firms produce pre-launch inventories. This process often involves high risk, not only due to the large amounts of time and capital investment, but also because the secrecy maintained across lateral competitors stifles market signals that ordinarily foster economic efficiency. Reconsideration of the Austrian theory of the business cycle in this light leads to additional insights about: 1) the capital consumption that occurs during the cycle; and 2) the timing of the bust that follows a boom inspired by excessive credit expansion. Our empirical study of return volatility for the period from 1996 to 2017: 1) confirms the results of a Journal of Finance study of the preceding period from 1975–1995; and 2) validates our analysis of new-product R&D as the earliest component of the capital structure.
KEYWORDS: research and development, R&D, business cycle, capital structure, capital consumption JEL CLASSIFICATION: E14, E32, O30 Our friends up north [at Microsoft] spend over five billion dollars on research and development and all they seem to do is copy Google and Apple. — Steve Jobs
I. INTRODUCTION Austrian economics emphasizes the idea that the price and production signals of competing firms coordinate capital use across the stages of production. This idea makes perfect sense for firms whose priced products are competing on the open market. For example, the price and production decisions of competing automobile manufacturers influence one another. On the other hand, the decisions of firms engaged in new-product research and development are largely uninformed by the decisions of other firms engaged in the research and development of similar products. Because, by definition, new-product R&D occurs prior to the pricing and open market sale of products, competing firms within this stage of the capital structure are largely ignorant of each other’s preparations.
In this paper, we deepen the understanding of the capital structure by unpacking the process that coordinates capital within the new-product R&D stage of the capital structure. The dearth of capital-coordinating signals emanating from the earliest stage of the capital structure is unique to the new-product R&D process. Signals, within the new-product R&D stage, are sparse for three reasons: 1) price and production signals do not exist for products still under development or prior to launch on the open market; 2) pre-launch inventories have minimal impact upon the market price of products already on the market; and 3) entrepreneurs, engaged in new-product R&D and seeking “first mover” advantage, have incentives to shroud their operations and discoveries in secrecy.
The evidence of entrepreneurial secrecy in new-product R&D can be found in the body of law dealing with trade secrets. Firms, engaged in new-product R&D, routinely require employees to sign: 1) “non-disclosure agreements” whereby employees obligate themselves to keep research and development activities secret; and 2) “invention agreements” that pre-specify the sharing arrangement for anything that employees invent during or as a result of their work on the firm’s new-products.“...[T]he term ‘trade secret’ means all forms and types of financial, business, scientific, technical, economic, or engineering information, including patterns, plans, compilations, program devices, formulas, designs, prototypes, methods, techniques, processes, procedures, programs, or codes, whether tangible or intangible, and whether or how stored, compiled, or memorialized physically, electronically, graphically, photographically, or in writing if—(A) the owner thereof has taken reasonable measures to keep such information secret; and (B) the information derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable through proper means by, another person who can obtain economic value from the disclosure or use of the information….” 18 U.S. Code § 1839. Definitions accessed online at: https://www.law.cornell.edu/uscode/text/18/1839. Together, the overt secrecy of entrepreneurs regarding new-product R&D and the absence of price and production signals reduce and/or delay the cost-dampening impact of inter-firm competition.
We organize the remainder of this paper as follows. In Section II, we present time lines that facilitate the understanding of: a) the roles that time and money play in sustainable new-product R&D processes; and b) the system-wide costs of entrepreneurial secrecy and the absence of competition-constraining price and production signals. In Section III, we explain how our more explicit discussion of new-product R&D: a) deepens understanding of “capital consumption” in Austrian business cycle theory; and b) offers new insights into the trigger and timing of credit expansion booms and busts. Section IV presents an empirical study that validates our emphasis upon new-product R&D as the earliest component of the capital structure—our study demonstrates for the period 1996 to 2017 the same positive association between share price volatility and R&D intensity found in a Journal of Finance study pertaining to the preceding period, from 1975 to 1995. A summary follows in Section IV.
II. SUSTAINABLE NEW-PRODUCT R&D The process of new-product research and development consists, by definition, of new product research followed by new product development. We define new product research as prospecting for new and viable innovations (the search for working prototypes). New product development is pre-launch production consisting of: (a) the productization of cost-efficient working prototypes; and (b) the production of enough initial inventories to meet the anticipated demand for products launched onto the open market.
The timeline shown in Figure 1 illustrates the process by which new-product R&D successfully delivers new products to consumers. Successful processes begin with idea-prospecting that leads to working prototypes. Next, working prototypes evolve into products with costs that end up, after product launch, to be sufficiently low for the products to generate at least normal expected returns. Finally, firms produce sufficient quantities of pre-launch inventories to meet expected demand and be competitive on the open market. The arrow in Figure 1 shows the successful start-to-finish new-product R&D process: from idea prospecting, to prototype, to productized pre-launch inventory, to marketing and distribution of the completed products on the open market, and finally into the hands of consumers.
Not all investments into new-product R&D will be successful; in fact, many are likely to fail. This is because across the new-product R&D stage shown in the Figure 1 timeline, there is, as mentioned in the introduction, a dearth of market signals. Again: 1) neither price nor production signals can exist for products in pre-production; 2) pre-launch inventories have minimal impact on the market price of products already on the market; and 3) in the pursuit of “first mover” advantage, firms engaged in new-product R&D routinely stifle signals about their operations.
Figure 1: Timeline of How New Products Reach Consumers
The dearth of market signals within the new-product R&D stage does not mean that no market signals inform capital use within this stage. Most importantly, as emphasized by renowned Austrian school thinkers (Mises, Hayek, Garrison, etc.), the interest rate at which firms borrow has its most significant impact upon the capital structure’s earliest components. Also price, production, and other signals from active markets, outside the new-product R&D stage, provide crucial guidance that usefully informs, directs, and constrains new-product R&D. Summarizing, the three market signals that most clearly inform capital usage in new-product R&D are: (1) the interest rate on loanable funds; (2) the price and production signals of related products (substitutes and complements) currently being exchanged on the open (post-launch) market; and (3) the prices of the inputs available on the open market.
In line with standard Austrian business cycle theory (ABCT), so long as these market signals from outside the new-product R&D stage are free from artificial constraints or subsidies, we anticipate that entrepreneurial error in new-product R&D will be constrained sufficiently to preclude malinvestment booms. But given the absence of lateral signals within the new-product R&D stage, again consistent with standard ABCT, there is every reason to suppose that an excessive expansion of credit will drive the interest rate below the natural rate, and swell entrepreneurial errors in new-product R&D, leading to an unsustainable malinvestment boom. Before discussing such an unsustainable boom, we begin below by first discussing sustainable levels of the entrepreneurial errors that occur—when investment is constrained by free market prices and the natural rate of interest. In particular we discuss three types of errors: (1) superfluous discovery; (2) duplicative discovery; and (3) duplicative development. We discuss each of these in turn.
Superfluous Discovery
Superfluous discovery occurs within the idea prospecting (research) phase of new-product R&D. Superfluous discovery occurs when prototypes, or models: 1) do not work; or 2) are economic dead-ends (because the costs of productizing and launching exceed the prototypes’ expected future returns. For example, in the academe, all those who have conducted significant amounts of research have made arguments that simply do not “work out.” There are a variety of reasons for unpublished academic research; among them: 1) the implications of the model are grossly inconsistent with observable, real-world behavior; and 2) the argument is unclear and/or unpersuasive to peer reviewers.
Duplicative Discovery
Duplicative discovery occurs when more than one entrepreneur, engaged in research, discovers the same working prototype, or model, simultaneously (or nearly simultaneously). Matt Ridley (2017) explains that many versions of the light bulb existed before Thomas Edison “invented” it:
Suppose Thomas Edison had died of an electric shock before thinking up the light bulb. Would history have been radically different? Of course not. No fewer than 23 people deserve the credit for inventing some version of the incandescent bulb before Edison, according to a history of the invention written by Robert Friedel, Paul Israel and Bernard Finn.
Ridley goes on to cite a famous example in the history of science—Darwin’s and Wallace’s simultaneous discovery of the theory of evolution.“Charles Darwin was a methodical man. Twenty-two years after the voyage of the Beagle, he was still working on his definitive study. Darwin, in fact, almost waited too long. In 1858, Alfred Russel Wallace also formulated a theory of evolution, based on his studies in Brazil and the East Indies. … [W]hen Wallace sent the manuscript of his findings to Darwin for his opinion, Darwin was astounded. Although Darwin’s first instinct was to give Wallace full credit for the theory, the two men agreed to present their papers in the same issue of the Journal of the Linnean Society. The next year, 1859, Darwin finally finished his book, On the Origin of the Species by Means of Natural Selection, or the Preservation of Favoured Races in the Struggle for Life; the popular title is The Origin of the Species.” (Ritchie and Carola, 1983, p. 509)
Duplicative Development
Duplicative development occurs when, following the awareness of increased demand for a product, a “swarm” of firms, not all of which will ultimately survive, make investments to bring similar products to market. For example, in early January of 2007, Apple Computer announced and demonstrated the iPhone. Shipment of the new device began in June of that year with great fanfare and significant market adoption. The success of the new smartphone served as an impetus for other firms to engage in developing competitive products. One after another, Palm, Blackberry, Microsoft, Samsung, Nokia, and the browser company Mozilla (creator of Firefox) among others, invested heavily in the development, prelaunch inventories, and launch of their smartphone offerings. The result of this entrepreneurial swarming into the smartphone space was a successful Samsung/Google Android phone and the original leader, iPhone from Apple. The others, unable to compete successfully in the crowded space, dropped out of the race or fell into obscurity.
The three entrepreneurial errors (again, superfluous discovery, duplicative discovery, and duplicative development) can reduce the overall ex post net benefit of the new-product R&D stage of the structure of capital. However, there is no reason to think that the market signals from outside this stage (i.e., prices of related goods, the prices of inputs, and the interest rate) will, absent distortions in these outside signals, so insufficiently constrain these errors as to cause the ex post net benefit of new-product R&D to be negative. Schumpeter’s oxymoron, “creative destruction,” is famous because new-product R&D has repeatedly delivered net benefits that are palpably positive.
This in mind, we argue that the new-product R&D process, absent governmental and/or credit distortions, will be sustainable—meaning that the ex post net benefits are positive. In Figure 2, we modify Figure 1 (which only addressed sustainable new-product R&D), to include the entrepreneurial errors of superfluous discovery, duplicative discovery, and duplicative development.
Figure 2: Sustainable New-Product R&D Timeline
As depicted in Figure 2, entrepreneurial errors appear in lengths and widths intended to depict sustainable levels, (that is, levels that result in the overall net benefit of new-product R&D being non-negative). As shown in Figure 2, the superfluous discovery arrow ends at the prototype line—this is the sustainable level, meaning that resources are not invested into productizing uneconomic prototypes or non-working innovations.
Similarly, the “duplication” arrow in research (this arrow represents the duplicative research) ends at the “Prototype” line. Once there is proof of the viability of a prototype, concept, or model, no more resources go to re-discovering it. In the case of the light bulb, as Ridley explained in his APEE presentation (2017), it resurfaced many times only because worldwide communications at the time limited the knowledge of the various inventors. Subsequently, once knowledge of the invention of the light bulb became widely known, reinvention of the basic bulb ceased.
Finally, Figure 2 features a “Duplication” arrow above “Devel-opment.” This arrow illustrates the level of duplicative initial inventory creation that is consistent with a sustainable new-product R&D process. Notice that this arrow ends at the launch line. This is not because duplicative products never reach final consumers, but because they soon cease to reach consumers—crowded out by the relatively more successful new product(s).
Returning to the cell phone example mentioned above, although many companies offered alternatives, today, only a few types remain on the market. In the period of a few decades, market competition winnowed the field. We do not know of any economist who argues that the costs of this winnowing process (the costs of duplicative development) are so large as to cast significant doubt about whether the research and development process that created cell phones delivered positive net benefits. In other words, the process that created cell phones was a sustainable one.
III. R&D MALINVESTMENT: ANOTHER SOURCE OF CAPITAL CONSUMPTION The original Mises/Rothbard/Hayek renditions of Austrian Business Cycle Theory (ABCT), as Salerno (2012, p. 15) explains, all agreed that 1) “malinvestment,” excessive investment in the earliest stages of the capital structure, is an essential component of the boom; and 2) “overconsumption” is an essential component of the boom, albeit with Hayek being “less emphatic.” In addition, “capital consumption” resulting from overconsumption during the boom, Salerno (p. 21) explains, is what ultimately leads entrepreneurs to abandon the “wholly new investment projects” undertaken during the boom.“[T]he increase in the prices and profitability of consumer goods diverts factors from higher stages to consumer goods’ industries, thereby restricting the supply of resources available to add to or even replace the stock of capital goods. This is what Austrian economists call “capital consumption,” which is a pervasive feature of the boom.” (Salerno, p. 16)
Our focus and more explicit discussion of new-product R&D, as the earliest component of the capital structure, provides a complementary explanation for the “capital consumption” that takes place during the boom (setting up an inevitable bust). Salerno’s emphasis that it is “wholly new investment projects”, in the earliest stages of production, that will be incentivized by the credit expansion (many of which will have to be abandoned due to “capital consumption”), dovetails with our focus on new-product R&D as the earliest component of the capital structure.
The additional source of capital consumption, that our unpacking of new-product R&D exposes, is straightforward. An artificially low interest rate, caused by the overexpansion of credit, will result in the bloating of Figure 2’s sustainable levels of superfluous discovery, duplicative discovery, and duplicative development (levels that were sustainable at the natural rate of interest) into unsustainable levels (levels incentivized by the artificially low interest rates). For complete clarity, Figure 2’s depiction of the sustainable R&D timeline is modified in Figure 3’s depiction of an unsustainable R&D time line.
Comparing Figures 2 & 3, the bloating of superfluous discovery, duplicative research, and duplicative pre-launch production is obvious. As documented and emphasized by Salerno (p. 5), “Austrian theory is not an ‘overinvestment theory’ of the business cycle and was never construed as such by its most notable proponents.” In line with Austrian theory and tradition, this means that the bloating of the arrows in Figure 3, relative to Figure 2, is not overinvestment, but rather malinvestment.
Figure 3: Unsustainable R&D (bloated Superfluous Discovery and Duplication)
In one crucial respect, malinvestments specific to the new-product R&D stage are like malinvestments in early stages of the capital structure generally. All malinvestments arising from credit expansion contribute to what Salerno (p. 22) aptly describes as the “... ‘hole’ in the middle stages of the structure of production, which is ‘papered’ over by profits and capital gains caused by the falsification of monetary calculation.” In one important respect, however, malinvestments in new-product R&D are unique. As we explained earlier, lateral competitors engaged in new-product R&D, with their products not on the market, are in the dark because they are literally uninformed by the price and production signals of one another.Recall from our earlier discussion that: 1) products under development are not yet on the market; and 2) in the pursuit of “first mover” advantage entrepreneurs in new-product R&D maintain secrecy about their activities.
The uniqueness of new-product R&D malinvestment is important because it offers new insights into: 1) why new-product R&D malinvestments will tend to pile up for a longer period than will malinvestments where price and production signals are present; and 2) what can trigger the bust, and when it will occur. Current Austrian explanations of what will trigger the bust, and when, are unspecific. Garrison (2001, p. 72), for example, explains only that “at some point in the process. . . entrepreneurs encounter resource scarcities that are more constraining than was implied by the patter of wages, prices, and interest rates that characterized the early phase of the boom. Here, changing expectations are clearly endogenous to the process.”Similarly, Salerno (p. 22) explains:As the boom continues, firms confront an increasing scarcity of the resources necessary to [for example] fully utilize the new mining and oil drilling equipment to construct the hydroelectric plant and to engineer and mass produce the new generation of aircraft. In a strictly metaphorical sense, then, we may say that the lengthened structure of production cannot be ‘completed.’ The anticipated demands for the products of the higher stage investment projects... do not materialize because of the greater scarcity and costliness of the complementary labor and capital needed to profitably transform these products into lower order capital goods.... From an economic point of view, malinvestment and capital consumption cause the structure of production to disintegrate into pieces that cannot be fitted back together again without a protracted recession-adjustment process.
Inspection of Figure 3 suggests an explanation of what can trigger the bust, and when. Recalling from our previous discussions that the capital usages within the new-product R&D stage are non-signal emitting, it becomes apparent that the “launch” line is key to understanding what triggers the bust. Again, prior to launch, there are no price and production signals to constrain lateral competitors. It is at the time of product launch, that price and production signals for newly developed products first emerge and begin to constrain and coordinate capital usage across the stages of production. All that need occur to trigger a crisis is for an excessive amount of duplicative pre-launch inventory to hit the market simultaneously, or nearly so, in a Schumpeterian swarm.An anonymous referee indicated that he/she, in discussing R&D as the earliest stage, emphasizes “the bringing to market of new capacity as a critical trigger (rather than pre-launch inventories).” Both are important, because both new capacity and the pre-launch inventories hitting the market can, if of sufficiently large magnitude, cause the price of competing products to collapse—and the price collapse is the defining characteristic of the bust. Empirical assessment of the relative importance of the new capacity relative to the launch of new inventories is beyond the scope of this paper. This insight can improve our understanding of the timing of monetary inspired crises as illustrated by the two cases examined in the next section.
IV. EVIDENCE OF GREATER VOLATILITY IN R&D-INTENSIVE FIRMS According to Austrian business cycle theory, excessive credit expansions drive the interest rate below the natural rate and, thereby, incentivize overinvestment in the earliest components of the capital structure. In line with this theory, it is expected that the uses of capital in the earliest stages would be more volatile over the business cycle as the interest rate deviates from the natural rate. In this paper, we have focused attention upon new-product R&D (pre-production investment) because it is the earliest component of the capital structure and because the activities of businesses in the new-product R&D space are sequestered—the price and production signals that ordinarily constrain and coordinate the stages of post-product-launch production literally do not exist to coordinate and constrain pre-production enterprises. If this focus is apt, then, empirically, we should expect to see greater volatility in the values of firms that are more heavily engaged in new-product R&D.
A. Extant Empirics on R&D Intensity and Return Volatility, 1975–1995
A relatively recent study in the Journal of Finance provides evidence on the impact of new-product R&D on return volatility over the period 1975 to 1995. Chan, Lakonishok and Sougiannis (2001, p. 2431) find that “R&D intensity is positively associated with return volatility.” Their explanation? Consistent with our discussion of new-product R&D as sequestered capital, they point out that research and development activity is, under “accepted U.S. accounting principles,” treated as an “intangible asset” and that this results in a general “lack of accounting information” which greatly “complicates the task of equity evaluation” (op cit.) for firms that are highly R&D intensive.Furthermore, studying the impact of this lack of information upon stock market valuations is important, they argue, because of the recent, “dazzling growth” in R&D intensive industries—“at year-end 1999, the technology sector and the pharmaceuticals industry together account for roughly 40 percent of the value of the S&P 500 index.” (op cit., pp. 2431–2432). To verify that these findings extend beyond the period from 1975 to 1995, the remainder of this section empirically investigates the relationship between R&D intensity and return volatility for the period from 1996 to 2017.
B. A Study of R&D Intensity and Return Volatility for 1996–2017
The purpose of this empirical study is to test the hypothesis
that the sequestered nature of new-product R&D implies that firm share-price return volatility increases as R&D intensity rises. Our study presents a series of four OLS panel-data regressions that estimate, for alternative specifications, the statistical and economic significance that new product R&D has on firm volatility. The regressions estimate the coefficient of three-year trends in the new product R&D (RD_Trend) of 3,668 publicly traded firms as a predictor of the dependent variables, Market_Beta and Total_Volatility.
Investors regularly rely on Market_Beta as a measure of potential risk, reflecting the volatility of a firm’s stock price compared with that of the market as a whole. A beta of 1 indicates that the firm’s volatility mimics the volatility of the market, while a beta greater than 1 reports the percentage increase in volatility of a stock above the volatility of the market. A beta less than 1 indicates a percentage decrease in volatility in comparison to that of the market.
To control for potential omitted variable bias, we have included the natural log of each firm’s annual total revenues as well as annual net income as a percentage of total revenues. All regressions include both year and firm fixed effects, to control for aggregate movements in the market (business cycles) and for attributes of firms and industries.
The data we use are from WRDS-Compustat. Table 1 presents descriptive statistics on the variables used in the regressions. As shown in the table there are 32,121 observations of which, for each firm, there are up to 21 annual observations (1996 to 2017.) The years 1993 to 2017 are included in the data. The years 1993 to 1995 are included to calculate the three-year averages of total revenues and total R&D expenses used in the regressions. The market beta values range from 0 to 16.42, representing a broad range of volatility compared to the market volatility of 1.
Table 1: Summary Statistics
Total Volatility represents the range of volatility on a firm basis over a three-year period. The Net Income values represent the actual net income divided by Total Revenues or a percentage of Total Revenues. The natural log of Total Revenues is calculated by taking the natural log of the Total Revenues in millions. The RD_Intensity variable is computed by taking the total R&D expense for the current year and the two prior years and dividing the total by the total of revenues over the same three years.
- Estimation Methods
To assess the relationship between share-price volatility and R&D intensity, we estimate the model
(1) yit = βRDIntensityit + αXit + μi + νt + εit,
where yit, depending on the specification, is either the Market Beta (a standard measure of performance volatility) or Total Volatility of each firm (i) in year (t). The vector RDIntensityit includes the average of the new product R&D as a percentage of total revenues for current year (t) and the previous two years. In estimations in which Market_Beta is the dependent variable, the coefficient estimates on RDIntensityit measures the percentage impact of an increase in R&D as a percent of total revenues on Market Beta—a 1 percent increase in RDIntensityit, the estimated coefficient is the predicted increase in Market Beta. When the dependent variable is Total_Volatility, a 1 percent increase in RDIntensityit results in an increase in the total volatility of the firm’s value by the percentage reflected by the coefficient.
All regressions include firm and year fixed effects, μi and νt respectively. Year fixed effects capture price movements in the market that are largely systemic and often representing business cycle impact. Firm fixed effects capture time-invariant firm observable and unobservable variables, such as product market focus. The identifying assumption in our model is that firm trends are parallel.
The Xit vector in the regression model includes firm financial variables such as the log of total revenues and net income as a percent of total revenues, aggregated to the firm and year level. We include these variables to control for the possibility that changes in firm size and profitability might affect volatility.
- Results
The estimation results of our empirical study are shown in Table 2. The table includes two sets of regressions run against Market Beta (regressions 1 and 2) and two run against Total Volatility (regressions 3 and 4.) In the first regression, column (1) of Table 2, the control variables for Total Revenue and Net Income are omitted to provide a comparison for evaluating their impact when included as shown in regression (2). The coefficient of RD_Intensity is 0.928 and is significant at the one percent level, suggesting that an increase of one percentage of total revenues expensed on R&D will result in an increase in the firm’s market beta of 0.928 or approximately 92.8 percent—an economically significant increase.
In the second regression, column (2) of Table 2, the control variables for Net Income and Total Revenue are added into the model. The coefficient on RD_Impact declines from the first regression to 0.629, remaining significant at the one percent level and suggesting that an increase of 1 percent in the percentage of total revenues expensed on R&D will increase the firm’s market beta by 62.9 percent. The control variables suggest, as expected, that firms with higher revenues and profits will have lower beta values and thus lower volatility.
Table 2: Empirical Findings, 1996–2017; Effect of Research and Development Intensity on Stock Volatility
In the third regression, column (3) of Table 1, the control variables for Total Revenue and Net Income are omitted to provide a comparison for evaluating their impact when included as shown in regression (4). The coefficient of RD_Impact is 0.136 and is significant at the one percent level, suggesting that an increase in the percentage of total revenues expensed on R&D will result in an increase in the firm’s total volatility by approximately 13.6 percent—an economically significant increase.
In the fourth and final regression, column (4) of Table 1, the control variables for net income and total revenue are included in the model. The coefficient on RD_Impact declines from the first regression to 0.0469, remaining significant at the one percent level and suggesting that an increase of 1 percent in the percentage of total revenues expensed on R&D will increase the firm’s market beta by 4.69 percent. As in regression (3), the control variables suggest a lower level of total volatility when a firm has higher revenues or net profits.
- Summary of our empirical findings for the period 1996–2017
The empirical results of the four panel-studies reported in Table 2 strongly suggest a causal correlation between increases in the percentage of revenues expended on new product R&D and significantly higher levels of price volatility. This finding is consistent with our hypothesis that the sequestered nature of new product R&D will lead to greater error on the part of investors in forecasting—resulting in greater volatility.
V. OVERALL SUMMARY According to Austrian business cycle theory, excessive expansions of monetary credit cause malinvestment in the earliest component of the capital structure. In this paper we have analyzed the implications of new-product R&D in its role as the earliest uses of capital. As we have explained, new-product R&D can be broken down into three sequentially occurring stages: 1) a research stage that discovers potential new products; 2) a development stage to turn the potential products into working prototypes and productize them; and 3) a final stage to develop (produce) pre-launch inventories. Throughout these three stages, capital is sequestered—for these pre-production stages laterally competing firms are in the dark about the prices and production that will, following product launches, emerge onto the open market. Consistent with this sequestration of capital in the earliest stages, we find that, consistent with a previous empirical study for the period 1975 to 1995, higher return volatility is associated with higher R&D intensity. By identifying three stages of new-product R&D as the earliest component of the capital structure, greater insight is possible into what will trigger malinvestment busts and when they are likely to occur.
Brian Simpson (2017) in responding to my lengthy review of his two volume Money, Banking, and the Business Cycle, provides a welcome opportunity to identify the main distinctions between Simpson’s business cycle theory and Austrian business cycle theory (ABCT). Simpson’s earnest pleas to the contrary, I nevertheless remain unmoved that he advances our understanding of ABCT. In his response, Simpson asserts I made several errors in my initial review. In this response to Simpson, I will narrow the focus by only discussing our differences about the nature of the business cycle, as this is what I understand to be of most fundamental importance.
When attempting to explicate a theory of the business cycle, it is important to identify and distinguish between those components that are necessary features of the cycle and those that are merely incidental. As is well documented in the economic literature, the key necessary factor of the business cycle is malinvestment in the intertemporal production structure. It is important to remember that the business cycle is a cycle. ABCT explains that recessions are endogenous market responses to booms generated by exogenous monetary inflation (Garrison, 1989, pp. 6–7). The important question to ask is what precisely causes the cluster of entrepreneurial error that results in the bust. After all something has to get the cyclical ball rolling.
To identify what this something is, Ludwig von Mises (2006a [1928]) developed what became known as Austrian Business Cycle Theory by bringing together and integrating three lines of economic thought. He incorporated Knut Wicksell’s concept of the natural interest rate, Eugen von Böhm-Bawerk’s capital theory in which he describes the intertemporal capital structure, and the Currency School theory of the effects of credit expansion via the issuance of fiduciary bank notes. Mises rightly extended the Currency School theory to include demand deposits which serve the same economic function as bank notes.
Mises (1954 [1912], 357–366; 1998 [1949], 535–583) explained that, in our modern monetary economy, bank credit expansion not funded by voluntary savings leads to capital malinvestment resulting in a boom/bust business cycle. Indeed, ABCT as it has been developed by numerous economists understand the cause of the malinvestment that triggers the business cycle to be due to artificially low interest rates (Garrison, 1989; 2001, pp. 69–71; Haberler, 1983 [1932], pp. 14–15; Hayek, 1967 [1935], pp. 54–65, 85–91; 2008 [1933], pp. 60–62, 67–68, 73–75; Huerta de Soto, 2006, pp. 348–360; Macovei, 2015, pp. 416–418; Mises, 1954 [1912], pp. 357–364; 1983, pp. 2–3; 2006a [1928], pp. 109–111; 2006b [1931], pp. 160–163; Rothbard, 1983 [1969], pp. 29–30; 2000, pp. 9–14; 2004 [1962], pp. 996–1004; Salerno, 2012, pp. 15–24; Sieroń, 2016, p. 313; Strigl, 2000 [1934], pp. 111–116). Simpson (2014, vol. I, p. 74) himself recognizes this. The interest rate’s essential role in the business cycle is nicely summed up by David Howden (2016, pp. 345–346) who recently notes, “the assertion that artificial reductions to the interest rate cause an unsustainable lengthening in the structure of production is the central tenet of the Austrian theory of the business cycle.”
Lending institutions create fiduciary money through credit expansion. Such credit expansion entails lower money interest rates because in order for banks to find willing borrowers, they must make them an offer they cannot refuse. Banks lower the loanable funds rate so there will be people willing to borrow the money the banks are eager to create.
This artificial lowering of the interest rate is the catalyst for the business cycle, because it generates an inflationary boom. Entrepreneurial ambitions expand immediately which increases economic activity. New businesses are started with the necessary capital funds that can be obtained by lower priced credit. In any given economic situation, opportunities for production that can actually be carried out are limited by the supply of capital goods. With credit expansion in the form of fiduciary money, new investment projects appear profitable because the interest rate for loans is now below the natural rate established by market. Note that this assessment by entrepreneurs does not hinge on increased revenues resulting from increased spending. It is the result of decreases in the costs of borrowing due to the artificially lower interest rates. Additionally, because the present value of capital goods is the sum of their future marginal revenue products discounted by the interest rate, a decrease in the monetary rate of interest causes an increase in the prices of capital goods, which in turn results in capital gains before any rise in sales. The lower interest rates, therefore, serve as the incentive for malinvestment before a firm’s revenues increase by even one dollar.
Businesses use the new money they borrow to bid away factors from other uses. Additional monetary units do not spontaneously create an increase in factors of production, so the stock of producer goods will be stable relative to the increased demand. Consequently, the prices of factors of production will increase.
The first prices to rise are those of raw materials, semi-manufactured goods, other higher order goods, and wage rates. Entrepreneurs will begin attempting to lengthen the structure of production. The prices of producer goods at stages farthest away from consumption increases. Resources begin to be shifted away from lower order uses to higher order uses. As these adjustments take place, the price differentials between products and their factors of production decrease all along the production structure.
This process is reversed as recipients of the new money spend it. The owners of original factors who receive increased money income allocate it according to their prevailing time preferences. Their spending will follow their same consumption/investment ratio. Production, therefore, no longer reflects voluntary time preferences. Businesses have been led to invest in higher stages of production as if more real savings were available, when in fact they are not. Businesses have overinvested in higher stages of production and underinvested in lower stages of production. ABCT sees the cluster of entrepreneurial error to be constituted in malinvestment, not overinvestment.
As the spending of the new money ripples through the economy, the price differentials between products and their factors of production will be reestablished at their previous larger spread. Prices of lower order goods will increase relative to those of higher order goods. Interest rates will increase to their previous levels. The monetary loan rate will follow the rate established in the production structure. It is even likely that the loan rate will spike up as businesses increase their demand for loans in the hope of saving their enterprises.
At this point, the crisis is revealed, and it becomes apparent that the expansion of business projects cannot all be brought to profitable completion. The new investment at higher stages will have to be liquidated or abandoned. Many new factories remain uncompleted. Other operations already completed shut down. Some still operate because, after writing off losses, they still generate some positive income. Entrepreneurial malinvestment induced by artificially low interest rates facilitating the expansion of credit in the form of fiduciary money sows the seeds of its own destruction. The process culminates in economic recession. Such are the basic outlines of ABCT.
We are now able to cast Simpson’s theory in bold relief. Simpson (2014, vol. I, pp. 57–62) does agree with ABCT by citing an increase in the money supply as the cause of the cycle. He also recognizes that such inflation is accompanied by a decrease in interest rates, attributing this to the necessary consequence of central bank open market operations (Simpson 2014, vol. I, pp. 29–32). While alluding to the effects of increased reserves on the loanable funds market, Simpson does not explain the precise role commercial banks have in the process of lowering interest rates.
While Simpson does acknowledge the effect inflation has on market loanable funds interest rates, he argues that the primary cause of the business cycle is faster than expected monetary inflation that results in faster than anticipated increases in spending, revenues, and return on investment (which he calls profit), because revenues are calculated based on current sales while costs are calculated based on past expenditure on durable capital goods (Simpson, 2014, vol. I, pp. 59–76). He does acknowledge that the artificially low interest rates also encourage increased investment because it lowers the cost of borrowing resulting in malinvestment (Simpson 2014, vol. I, pp. 73–74, 76–78, 80). Simpson (2014, vol. I, p. 74) stresses, however, that
While the effect of interest rates is important, much more emphasis needs to be placed on the rate of profit. This is the more important variable. The rate of profit is the primary reason why businessmen and entrepreneurs invest. The interest rate is secondary….
Finally, Simpson argues that, just as faster than expected monetary inflation causes the boom, when the central bank begins to decrease the money supply or merely increase it at a rate lower than anticipated, the economy will contract.
We are now at the point to provide some comparisons between Simpson’s theory of the business cycle and ABCT. In the first place, ABCT sees the problem primarily as one of malinvestment, that is, investment in the wrong stages of production. Simpson barely touches on this and relegates it to decidedly secondary status. However, it is at the heart of ABCT.
Caused by artificially low monetary interest rates, malinvestment is not dependent on changes in inflationary expectations. The artificially lower interest rates make investment in some projects more attractive even if expectations about future revenues and rate of return on investment remain constant. This is precisely why, contrary to Simpson (2017, p. 261), the economic definition of profit is important. Interest is a cost of production. If borrowing costs decrease, projects appear more profitable even if the return on investment remains the same. Entrepreneurs, therefore, have the incentive to begin new or expand existing production projects even before the effects of increased overall spending are manifest throughout the economy.
In ABCT any effects of increased spending on entrepreneurs’ return on investment due to calculating costs based on historical spending on durable capital goods are, in fact, of secondary importance in explaining the malinvestment that is the key to the business cycle. Austrians who have contributed to the development of ABCT do recognize that these effects can occur (Mises, 1998 [1949], pp. 546–547; Huerta de Soto, 2006, pp. 365–366). Such effects, however, are decidedly secondary in terms of importance, logic, and chronology. They can prolong the boom and therefore contribute to its magnitude. They are not, however, the cause of the cycle. The malinvestment that is the source of the boom/bust cycle is triggered by artificially low interest rates and the lending of new fiduciary money that is borrowed and invested before any change in macroeconomic expectations.
Additionally, wages and land rents will begin to rise sooner than later, because entrepreneurs who get the new money first must bid factors away from their alternative uses. This necessitates offering higher prices for their services. Production costs also would, therefore, increase sooner rather than later.
I continue to maintain that, as I said in my original review, Simpson’s theory seems more akin to New Classical Money Surprise Theory (Ritenour, 2016, p. 386). According to Simpson, the cause of the cycle is a large, unanticipated increase in money supply by the central bank. Such inflation results in increases in spending, prices, and revenues. Higher revenues increase firm rates of return on investment, thereby providing incentives for firms to expand output. The downturn only occurs when the rate of inflation slows, thereby decreasing rates of return below what is expected. Malinvestment in the capital structure is an afterthought at best.
In Simpson’s response to my initial review, he rightly exhorts the reader not to reject a theory merely because it is different (Simpson, 2017, 264). No exposition of a theory is correct either merely because it is old and well received or because it is new and previously unknown. An economic theory is correct to the extent that it can explain the issue at hand. Austrian business cycle was developed to explain the nature of the boom/bust cycle in the economy. This theory explains that the business cycle is the result of malinvestment within the intertemporal production structure fostered by monetary interest rates pushed artificially low by credit expansion, not funded voluntary spending. Because Simpson identifies larger than expected return on investment due to large unexpected rates of monetary inflation as the cause of the cycle, his theory misconstrues ABCT’s explanation of the cause of the cycle. I continue to maintain that Simpson may have a business cycle theory, but his is not Austrian business cycle theory.
In 2010, I argued in “America’s Second Great Depression”Mark Thornton, “America’s Second Great Depression: A Symposium in Memory of Larry Sechrest,” Quarterly Journal of Austrian Economics 13, no. 3 (Fall 2010): 3–6. that the US economy was in an economic depression and that it would likely continue for some time until economic policy was reversed. This was one of six papers organized as a symposium in honor of the late Larry Sechrest at the Southern Economic Association’s 2009 convention. While this assessment is a matter of debate, there are plenty of important mainstream economists that agree that current conditions have much more in common with an economic depression than normal economic growth.
An economic depression is a multiyear contraction of economic activity noticeably below the economy’s potential. Great depressions are even longer and deeper and can be interspersed with periods of contraction and expansion. There is nothing in economic theory that can determine whether an economy is in a recession, depression, or great depression. These labels are a matter of assessment, opinion, and professional standards and are subject to change.
Instead of addressing how “great” current economic conditions are, this chapter examines theories of the business cycle and how well they appear to perform in light of economic policies that have been enacted since 2007 in the United States and the global economy.
The Great Depression was clearly a great depression in both its length and depth. In addition, it was a worldwide phenomenon. As Professor HiggsRobert Higgs, “Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s,” Journal of Economy History 52, no. 1 (March 1992): 41–60. has shown, the United States never really recovered from the Great Depression until after World War II in terms of inflation-adjusted per capita consumption.
I have also suggested that the stagflation of the 1970s (1970–82) was an economic depression. It was certainly long enough, and it was not confined to the United States. Statistically, it might not have been as bad as the Great Depression. There were economic expansions during the period, but the economy failed to keep up with its potential. However, in contrast with the past, it did inflict both high inflation and high unemployment — that is, stagflation — on the population, simultaneously, really for the first time.
It might surprise you to learn that great depressions are not purely monetary phenomena. Throughout this book great attention has been paid to the phenomenon of central banks’ artificially low interest rate monetary policy causing a business cycle. However, business cycle expansions and contractions are typically of a much shorter time span than a great depression.
Depressions begin with a considerable period of monetary expansion followed by an economic crisis. RothbardMurray Rothbard, America’s Great Depression, 5th ed. (Auburn, AL: Mises Institute [1963] 2000). shows that there was a considerable period of monetary expansion prior to the stock market crash in 1929. Rothbard’s calculation of the money supply in the 1920s has been challenged by Timberlake.Richard Timberlake, “Money in the 1920s and 1930s,” Freeman (April 1999): 37–42. However, SalernoJoseph Salerno, “Money and Gold in the 1920s and 1930s: An Austrian View,” Freeman (October 1999): 31–40. Reprinted in Joseph T. Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2010), pp. 431–49. has shown that even if you remove the “offending” categories from calculations of the money supply — for example, the cash value of life insurance policies — monetary policy in the 1920s was still highly expansionary.
Turning the crisis into a depression or great depression requires a significant and sustained effort on the part of the government to use various policies in an attempt to stop and reverse the corrective market process — that is, the economic crisis. In other words, the dominant ideology is some variation of Keynesianism, and the government’s response to the crisis involves, among other things, an expansionary monetary and fiscal policy. RothbardRothbard, America’s Great Depression. showed that President Hoover’s policies were intended to keep wages and prices high. This turned an ordinary economic crisis into the Great Depression. Hoover’s “New Deal-like” policies included maintaining high prices and incomes, stimulating the economy with public works projects, loans, bailouts, protectionism, and currency devaluation. HerbenerJeffrey Herbener, “Fed Policy Errors of the Great Depression,” in The Fed at One Hundred: A Critical Review on the Federal Reserve System, edited by David Howden and Joseph T. Salerno (Springer, 2014), pp. 43–45. shows that the Fed was interventionist, with a low interest rate monetary policy until 1937. Ohanian and ColeLee E. Ohanian and Harold Cole, “New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis,” Journal of Political Economy 112, no. 4 (August 2004): 779–816. and OhanianLee E. Ohanian, “What—or Who—Started the Great Depression?” Journal of Economic Theory 144 (October 2009): 2310–2335. empirically verified the Rothbard hypothesis. Hoover’s and later Roosevelt’s policies became the basis of what would become Keynesian economics.Arthur Okun, The Political Economy of Prosperity (Washington, DC: Brookings Institution, 1970). Keynesian ideology was also the dominant force during the stagflation of the 1970s and in the Japanese economy from 1989 to the present.
The alternative approach to business cycle contractions is espoused by the classical economists, the Austrian-school economists, and the real business cycle theorists. This “do nothing” approach involves shrinking government and balancing the budget, expanding resources in the private sector, and a nonexpansionary monetary policy. This was employed by Presidents Woodrow Wilson and Warren G. Harding during the fifteen-month-long depression of 1920–21. This period was one of the most severely deflationary in US history, and yet it is hardly mentioned in history textbooks.
James GrantJames Grant, The Forgotten Depression: 1921: The Crash That Cured Itself (New York: Simon & Schuster, 2014). found that the reason this depression was so short was because it largely cured itself before government meddling could begin. Thomas WoodsThomas E. Woods, “Warren Harding and the Forgotten Depression of 1920,” Intercollegiate Review (Fall 2009): 22–29. shows that Harding was really a “do something” liquidationist in the sense that he wanted to reduce the size of government and raise interest rates to actively stamp out the inflation from World War I. There has been some quibbling regarding the timing and effect of various policies and policy changes, but Patrick NewmanPatrick Newman, “The Depression of 1920–1921: A Credit Induced Boom and a Market Based Recovery?” Review of Austrian Economics (January 2016): 1–28. has decisively shown that a liquidationist policy was dominant before the recovery began.
In the chapter to follow, I will present a simplified version of business cycle theories and discuss what those theories would recommend as policy remedies for economic crises, and how well those remedies worked in the wake of the financial crisis. See BagusPhilipp Bagus, “Modern Business Cycle Theories in Light of ABCT,” in Theory of Money and Fiduciary Media: Essays in Celebration of the Centennial, edited by Jörg Guido Hülsmann (Auburn, AL: Mises Institute, 2012), pp. 229–46. for a more in-depth Austrian critique of modern mainstream business cycle theories.
What this book has established is that the central bank causes a variety of economic problems and that Austrian business cycle theory (ABCT) shines a scientific light on what otherwise is a highly complex phenomenon. I have shown that the Skyscraper Index has predicted most of the important economic crises for over a century. I have also shown that Austrian economists have predicted those crises using ABCT.
Now the question arises: what are the problems and what can be done about them? The two most obvious problems with central banking and the monetary inflation that flow from them are the boom/bust business cycle and inevitable price inflation. Embedded in the process of monetary inflation and price inflation is a degenerative process of economic inequality that is so apparent today. This effect on economic inequality and the channels through which it flows are described in further detail by Hülsmann.Jörg Guido Hülsmann, “Fiat Money and the Distribution of Incomes and Wealth,” in The Fed at One Hundred: A Critical Review on the Federal Reserve System, edited by David Howden and Joseph T. Salerno, (New York: Springer, 2014), pp. 127–38.
Monetary inflation depends on who gets the money and credit first and who gets it last. As fiat money is created by central banks, private banks are in a position to expand the amount of loans they make. The wealthy have established relationships with the banks, and they have the real estate and assets to provide collateral for the loans. Large, established companies and wealthy individuals are in favorable positions relative to small businesses and people with low or average incomes. The loans allow big companies and wealthy individuals to invest in capital goods during the boom phase of the business cycle. Central banks thereby create artificial inequality and poverty. This is the primary Cantillon effect of redistributing wealth.
We have rarely had a true “free market” in money and banking. The American colonies were controlled by English mercantilist policies. The antebellum era experienced the business cycles created by the First and Second Banks of the United States, which were essentially primitive central banks. Between the end of the Second Bank of the United States and the National Banking System was the era of “free banking.” This period best approximates a free market in money and banking because gold and silver coins served as money, entry into the banking business was relatively easy, and bank reserves were kept relatively high compared to demand deposits. Government spending and government intervention were historically very low. This period experienced the highest rates of economic growth in US history, but it was not perfection, as many state free-banking laws contained poisonous provisions that undermined the stability of banking.
The National Bank Acts were passed during the Civil War and “regulated” money and banking until the Federal Reserve Act was passed in 1913. The Fed and WWI effectively ended the classical gold standard and replaced it with the gold exchange standard. In 1933 all privately held monetary gold was confiscated by the federal government, and the nominal book value of gold was changed from $20.67/ounce to $35/ounce. The post-WWII Bretton Woods gold standard allowed other central banks to convert $35 into an ounce of gold, but it also freed the Fed to essentially print gold. This arrangement eventually became untenable when other central banks began converting dollars into gold. President Nixon closed the “gold window” on August 15, 1971.
Since that time the world has been on a fiat monetary system where currencies are not convertible and exchange rates between currencies are “flexible.” The power and authority of central banks has continued to expand over time. The money supplies and central bank balance sheets have continued to expand, and the value of currencies has continued to decline. For example, in mid-2008 the total assets of the Federal Reserve were less than $900 billion. By mid-2014 their total assets were over $4,400 billion. The Fed acquired these additional assets of government bonds and mortgage-backed securities by printing electronic dollars. As a reference point, measured in gold, the dollar is currently worth less than two cents of the pre-Fed dollar. The Bank of Japan, the People’s Bank of China, the European Central Banks (ECB), and other central banks around the world are pursuing similar policies in an undeclared currency war.
MurphyRobert Murphy, “Ben Bernanke, the FDR of Central Bankers,” in The Fed at One Hundred, edited by Howden and Salerno, pp. 31–42. shows that the Fed’s responses to the financial crisis were overwhelming, unprecedented, and of dubious statutory authority. These responses were so egregious that Murphy labels Ben Bernanke the FDR of monetary policy. Despite the Fed’s efforts, Murphy concludes the policies have not worked. The ECB has also overstepped its statutory authority from the European Union in response to the European debt crisis, to no avail.
Have these policies worked well? There has been a constant debate since 2008 over whether the economy has recovered and is growing, or whether it is mired in a lingering recession. There are supporters of both views from across the political and economic spectrums. The real dividing line depends on the relationship the person has with the establishment. Supporters of the establishment contend that the economy survived and recovered, while opponents of the establishment generally consider the economy to be broken and regressing.
The battle between these two views is generally undertaken with contending sets of statistics regarding GDP, unemployment, and price inflation. Austrian economics settles the issue by looking at things such as the big increases in government spending, deficit-financed spending, and the questionable value of investments financed with artificially low interest rates since 2008. Austrians argue that the real market value of increased government spending and malinvestments is far less than the dollars expended. Thus the resulting GDP statistics are very dubious. This analysis suggests that the US economy is regressing on a long-term basis and that we are much deeper in debt as a result.
In fact, EngelhardtLucas Engelhardt, “Unholy Matrimony: Monetary Expansion and Deficit Spending,” in The Fed at One Hundred, edited by Howden and Salerno, pp. 139–48. and others have argued that a central bank facilitates the process of deficit financing and the accumulation of a large national debt. A central bank can always print money to pay for the national debt, or print money to buy up the national debt, as the Fed is doing today with its various quantitative-easing policies. The US government had a debt of around $370 billion to begin the 1970s. At the end of 2007 the national debt was $9.3 trillion, and it more than doubled before the end of 2015 to a debt of $18.9 trillion and it continues to grow. In 1970 the national debt was the equivalent of 34 percent of GDP. In 2015 the national debt as a percentage of GDP was more than 100 percent. A large national debt is a negative drag on the economy and can even result in hyperinflation. SalernoJoseph T. Salerno, “War and the Money Machine: Concealing the Costs of War beneath the Veil of Inflation,” Journal des Economistes et des Etudes Humaines 6 (March 1995): 153–73. Reprinted in Joseph T. Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2010). has shown that central banks also facilitate unnecessary and expensive wars because the central bank can conceal the true costs of war from the citizens.
However, as a best-case scenario, let us make the heroic assumption that all that government spending was really valuable — that is, a dollar of additional government spending produced a dollar of consumer value — and that all those investments made between 2008 and the present will turn out great. If we take the government’s measure of the economy (i.e., GDP) and adjust for the government’s measure of price increases (i.e., the GDP deflator) and then adjust that figure by the increase in population, we find that the US economy grew at less than 4 percent over the entire period from 2008 to mid-2016. Compare that to the years during the free-banking era (1837–62) when inflation-adjusted, per capita GDP growth was 3 percent or even higher per year. That is a stark contrast.
It is not a mystery as to what has caused economic malaise in the US economy. In this, we note three important factors. First, the amount of debt that has accumulated in the US economy is enormous. The amount of debt of government, businesses, and consumers has soared over the last forty-five years, and this is no doubt linked to suppressed–interest rate policy and a depreciating currency generated by the Fed. Traditionally, the total amount of debt in the United States was about 1.5 times GDP or less. Today it is about 3.5 times GDP. In other words the debt burden is too high. Second, the personal savings rate in the United States has fallen dramatically. Prior to 1971 the average personal saving rate, as measured by the government, was over 10 percent. Since 1971 the personal saving rate has declined to as low as 2 percent during the housing bubble, although it has recovered to an average of over 5 percent since the financial crisis. The Fed’s suppressed–interest rate policy and depreciating currency are the major, but not the only causes of the low personal savings rate. Third, the regulatory burden in the US economy has increased enormously over the last half century, and the amount of and burden of regulation has only accelerated since the financial crisis in the form of Dodd-Frank financial regulation and the Affordable Care Act.
The reduction in savings and the increase in regulatory burden have caused the reduction in productivity growth. A lack of productivity growth explains the stagnation in wages and the lack of high-wage job growth. Any remaining income growth has been absorbed by the increased cost of financing debt, higher taxes to finance government debt, and mandated job benefits, such as medical insurance. All of this comes on top of the fact that family incomes have been stagnant or declining for a decade and a half. Meanwhile, billionaires thrive.
With the Fed passing one hundred years of age in 2014, there have been many retrospectives on the general value of this institution. There have been some favorable and encouraging reviews from inside the Fed, but most outsiders have taken an entirely negative stance on the very existence of the Fed and the place of central banking in a healthy and free society.
White,Lawrence H. White, “The Federal Reserve System’s Influence on Research in Monetary Economics," Econ Journal Watch 2, no. 2 (August 2005): 325–54. for example, questions the influence and impartiality of the Fed. The Fed spends vast resources on economic policy research, particularly on money, banking, and macroeconomics. This funding, as both carrot and stick, has no doubt produced a status quo bias in academic research on subjects that are the concern of the institution of the Fed. According to White:
The Fed employed about 495 full-time staff economists in 2002. That year it engaged more than 120 leading academic economists as consultants and visiting scholars, and conducted some 30 conferences that brought 300-plus academics to the podium alongside its own staff economists. It published more than 230 articles in its own research periodicals. Judging by the abstracts compiled by the December 2002 issue of the e-JEL, some 74 percent of the articles on monetary policy published by US-based economists in US-edited journals appear in Fed-published journals or are co-authored by Fed staff economists.Ibid., p. 235.
White puts the size of the Fed’s research staff into perspective by noting that the Fed’s staff of economists in 2002 was 27 percent larger than the number of macroeconomists and experts in money and banking employed by the top fifty PhD-granting economics departments in the United States combined. The Fed has numerous research journals that publish an enormous number of articles, but the articles that are published are vetted by the staffs at both the regional Fed banks and the Board of Governors in Washington, DC. This no doubt creates a tremendous bias against criticism of the Fed itself.
White also found that the Fed dominates the editorial boards of the leading academic journals specializing in money, banking, and macroeconomics. At the time of his research, one of the two main editors of the Journal of Monetary Economics and eight of the nine associate editors (82 percent) had one or more affiliations with the Fed. At the Journal of Money, Credit, and Banking, all three of the main editors and thirty-seven of the forty-three associate editors (87 percent) had Fed affiliations. Therefore not only does the Fed dominate the profession in terms of carrot-and-stick resources, but it also nearly acts as a universal gatekeeper at both the Fed and non-Fed academic journals dealing with money, banking, and macroeconomics. Not only is the Fed political in defense of its institutional power, but DiLorenzoThomas DiLorenzo, “A Fraudulent Legend,” in The Fed at One Hundred edited by Howden and Salerno, pp. 65–74. has shown that the “independence” of the Fed from the political process is a complete myth.
Selgin, Lastrapes, and WhiteGeorge Selgin, William D. Lastrapes, and Lawrence H. White, “Has the Fed Been a Failure?” Journal of Macroeconomics 34, no. 3 (September 2012): 569–96. examined the Fed’s track record and found it lacking in comparison to the National Banking system. With the exception of the Fed’s role in regulating banks, they examined its roles in controlling inflation and deflation as well as volatility of output and employment; the role of the Fed in the Great Moderation; and the frequency and distribution of recessions, banking panics, and lender-of-last-resort lending. They then evaluated the results against prior monetary experience using standard empirical techniques and published research.
They showed that prior to the Fed, the purchasing power of the dollar had long-term stability. In comparison, the Fed has produced powerful bouts of both inflation and deflation and greatly degraded the value of the dollar over the long term. There has also been a trend of increased volatility and decreased predictability of the changes in purchasing power of the dollar, making long-term plans and contracts more difficult. They found that the declining rate of inflation that occurred during the Great Moderation should be attributable to other factors than the Fed’s monetary policy. Finally, they showed that the Fed has not reduced panics or improved on its function as lender of last resort. In other words, the Fed has failed to match or exceed the results of the previous monetary regime. Historian Thomas WoodsThomas E. Woods, “Does U.S. History Vindicate Central Banking?” in The Fed at One Hundred, edited by Howden and Salerno, pp. 23–30. confirms that the problems of the pre-Fed money-and-banking system were the result of various government interventions, but that it was still better than the Fed. KleinPeter G. Klein, “Information, Incentives, and Organization: The Microfoundations of Central Banking,” in The Fed at One Hundred, edited by Howden and Salerno, pp. 149–62. and IsraelIsrael, Karl-Friedrich. “The Costs and Benefits of Central Banking,” PhD dissertation, Department of Law, Economics, and Business Administration, University of Angers, France, 2017. show that the institutional features of a central bank are inherently destabilizing.
ThorntonMark Thornton, “Transparency or Deception: What the Fed Was Saying in 2007,” Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 65–84. investigated the role of transparency in the conduct of the Fed’s monetary policy. Transparency is the notion that central banks reveal information about the concerns, intentions, and policies to the general public and particularly to specialists in markets and other central banks so as to not unintentionally shock markets with negative news. Generally, transparency by central banks has expanded over the last twenty-five years. Research on transparency has shown that increased central bank transparency has produced either positive or negligible effects on things you can measure with numbers, such as stock markets and interest rates. Instead of a statistical examination, Thornton reviewed the public statements prominent Fed officials made to groups of market specialists during 2007, the year between the housing bubble and the beginning of the financial crisis. He found that in these prominent public addresses, Fed officials consistently made misleading statements that often verged on deception. Economist Shawn RitenourShawn Ritenour, “The Federal Reserve: Reality Trumps Rhetoric,” in The Fed at One Hundred, edited by Howden and Salerno, pp. 55–64. has confirmed that the Fed has consistently used its rhetoric to promote the incorrect view that the Fed solves economic problems, it does not create economic problems.
Given the current scenario and the above analysis, what changes have to be made in order to create an economic environment that produces a stable economy without artificial redistribution of wealth? It would seem that the economic mess might be a web of problems too large and too tangled to solve, but that is not the case.
Let us begin with what are the ultimate goals. It should be clear that given the economic and historical analysis in this book that the goal here is to reestablish genuine markets for money and banking without government regulations and privileges. Market forces alone should regulate money and banking, just like the markets for aspirin, shoes, and cell phones. The following recommendations, couched in this respect, should not be considered a matter of mere opinion.
This seems like a tall task, but the process can begin on day one. The first thing to do is to disband the Federal Open Market Committee (FOMC) and allow the interest rate in the federal-funds market — the federal funds rate, which banks charge other banks for short-term loans — to be determined by market forces. The FOMC consists of the seven members of the Board of Governors in Washington, DC (political appointees), the president of the New York Federal Reserve Bank, and four rotating Federal Reserve District Bank presidents from the remaining twelve Federal Reserve District Banks. Their job is superfluous at best. This central-planning committee is the source of all the problems described in this book. It should be disbanded and its interest-rate–setting authority abolished.
The entire Federal Reserve System should be shutdown. Its legitimate functions, like check clearing, should be privatized. Gold on its balance sheet should be used to redeem Federal Reserve Notes for “gold dollars” equal to some established weight of gold. The Fed’s holdings of US government bonds should be cancelled and other assets should be turned over to the US Treasury. Howden and SalernoDavid Howden, and Joseph T. Salerno, “A Stocktaking and Plan for a Fed-less Future,” in The Fed at One Hundred, edited by Howden and Salerno, pp. 163–69. offer a similar plan, and SalernoJoseph T. Salerno, “Will Gold Plating the Fed Provide a Sound Dollar?” in The Fed at One Hundred, edited by Howden and Salerno, pp. 75–90. finds that most of the other types of plans to return to a “gold standard” do not work and that a “gold plated standard” does not stabilize the dollar or the economy.
All taxes on capital gains on gold and silver should be eliminated along with taxes on anything else that might emerge as a new type of money — for example, Bitcoin and copper. Legal tender laws should also be repealed so that people are not forced to use any particular type of money. Currently it is possible to deposit dollars into gold banks and make payments using a variety of media, such as checks or debit cards, but you have to pay capital gains taxes if a payment generates a capital gain.
Federal insurance of demand deposits should be eliminated. This would be replaced with banks complying with laws regarding other deposit-taking institutions, such as grain warehouses. They would be forced to use their own capital or money raised by selling bonds to make loans. By charging fees on the use of demand deposits (i.e., checking accounts) and offering interest on bonds, banks would reduce the amount of demand deposits and increase their long-term bonds. This would help solve the perennial problem of banking — borrowing short term, but lending long term. Banks would effectively be 100 percent reserve institutions. Banks would probably receive a great deal of deposits and bond purchases from the now largely irrelevant investment demand for gold, as hoarders of gold would have no reason to hold gold and more reason to invest in gold bonds in order to earn interest, instead of hoarding gold. The personal saving rate would no doubt increase. See Askari (George Washington University) and Krichene (International Monetary Fund)Hossein Askari, and Noureddine Krichene, “100 Percent Reserve Banking and the Path to a Single-Country Gold Standard,” Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 29–64. for a full explanation of the nature and history of 100 percent–reserve gold standard reform and the impressive list of noteworthy economists who support it.
None of this would be easy or free of disturbance. The highly leveraged economy would likely face a painful deleveraging process, concentrated in industries that benefitted most from the fiat-money central bank regime. There would probably be a massive wave of bankruptcies, foreclosures, defaults, and other legal and entrepreneurial solutions. The national debt would be in precarious shape and would have to be openly repudiated rather than the current process of default by inflation. The national debt could be put under the control of a legal custodian who would make payments from sales of government assets. If Obamacare, Medicaid, Medicare, and Social Security were significantly reformed and replaced with market institutions, the federal government appears to have enough assets to pay off the national debt and to meet its obligations. The federal government would probably not be able to draw additional credit, but forcing future generations to pay for past mistakes is an abhorrent practice. Massive budget cuts would have to be passed in order to balance the budget and to reestablish a market economy free of government intervention. The more government intervention that can be removed, the better the process of economic adjustment and the faster the economy will adjust and grow.
This process would involve deflation or falling prices. Mainstream economists have an unwarranted phobia of deflation. They think that deflation causes economic crises from which an economy cannot ever escape. Austrians have shown that deflation is actually the corrective process by which asset prices and wages fall relative to consumer goods, thus creating profit opportunities for entrepreneurs to reorganize and employ such resources.
With the United States moving to a 100 percent reserve gold standard, the value of the gold dollar would be fixed as a weight of gold. The exchange value would increase relative to other world currencies, and Americans would be made richer by the fact that their incomes and savings would buy more. It would be increasingly difficult to import goods into the United States. This would put pressure on other countries to follow the United States’ lead in adopting the gold standard and other monetary reforms. With the United States also cutting back on military and regulatory spending and selling vast amounts of resources to the private sector, the standard of living would quickly recover and the economy would experience high rates of economic growth.
Most people would not want to take the risks imagined by these recommendations. Politicians know this and exploit it. They and mainstream economists have plenty of horror stories to scare everyone else. However, SalernoJoseph T. Salerno, “The 100 Percent Gold Standard: A Proposal for Monetary Reform,” in Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2014), pp. 333–63. has shown that the standard criticisms of the gold standard are baseless.
The truth is the alternative of not reforming the system is much, much worse. As the dollar status as a reserve currency for other central banks worsens, the likelihood that some other government embarks on such a reform process increases. The government is too big, the national debt is too large, savings are too low, the money supply has been expanded too much, and the extent of artificial inequality threatens the fabric of cooperative society. These problems will only get worse over time and will end in hyperinflation, where that fabric is finally set ablaze on a bonfire of worthless paper money and government bonds.
The events in Washington, DC, today in 2018, represent a stalemate between President Trump and the establishment. This stalemate sustains the status quo at a time when there is radical rumbling on both left and right. Despite marginal reforms in taxation and regulation and despite the Fed’s announced reversal of policy, nothing remotely has changed to address the calamity that lies ahead, and that I’ve discussed throughout this book.
You could probably go back in history and find examples of the skyscraper curse in structures such as the Egyptian pyramids and medieval cathedrals. Here the review is confined to modern buildings, but we will expand our time horizon to examine records prior to and after the original Skyscraper Index (1907–99). We will also reexamine the one record-setting building, the Woolworth Building, that Andrew Lawrence considered a failure of the index because no curse occurred. As a result of this reexamination, the Skyscraper Index appears more reliable than previously thought.
This reexamination will consider modern buildings with steel-frame construction. The primary criteria for record-breaking projects are the number of floors of livable space and building height, not counting features such as antennas and spires. Those types of adornments are not costly or technologically challenging, compared to difficulties of building taller buildings with more livable space, which have requirements for such things as elevators, plumbing, and temperature control.
The two important inventions that made skyscraper construction feasible were the elevator and the steel-frame construction technique. Prior to the introduction of elevators in the 1850s, construction was typically limited to four-story buildings. Before the introduction of elevators, the lower floors were more highly valued and the higher floors were less highly valued because of the added time and effort of climbing more stairs. This limited the demand to build higher. With elevators, the higher floors became more highly valued, with the exception of first-floor retail space. The introduction of steel-frame construction in the late nineteenth century made it much more cost effective to build taller structures. Steel-beam construction bears the load or weight of taller buildings, and construction can proceed at a faster pace. In contrast, masonry construction requires an ever-larger base to carry the load of taller buildings.
The Equitable Life Assurance Building in New York City is considered by many to be the first skyscraper. Construction was completed in early 1870 and the building opened on May 1. It served as the home of the Equitable Life Assurance Society and was the first office building to feature hydraulic passenger elevators. It had seven floors and set a new record height at 130 feet.
Prior to its opening and approximately when it set the record height, the first Black Friday occurred on September 24, 1869. Jay Gould and James Fisk were attempting to corner the gold market in New York City, but US Treasury officials broke up their plot by selling large amounts of gold. Nevertheless, the economy was adversely affected as the price of gold first skyrocketed and then collapsed. In the aftermath, stocks fell by 20 percent and agricultural exports, the key output of the US economy, declined by 50 percent. According to Robert Kennedy,Robert C. Kennedy, “Gold at 160, Gold at 130,” Harper’s Weekly, October 16, 1869. there were several bankruptcies of brokerage firms “and a severe disruption to the national economy for months.” The aftermath has been labeled both a panic and a depression, but not a significant one.
The Home Insurance Building was completed in 1884 in Chicago. It rose to a height of ten floors and 138 feet. Interestingly, two more floors were added in 1890. This building is connected to the panic of 1884 and the depression of 1882–85. While the financial panic was real, the depression that occurred was mostly about deflation and the railroad bubble. According to Victor Zarnowitz,Victor Zarnowitz, Business Cycles: Theory, History, Indicators, and Forecasting (Chicago: University of Chicago Press, 1992), pp. 221–16. his measure of economic activity indicates that the depression was less severe than the panics of 1873 and 1893 and the depression of 1920–21.
The Auditorium Building in Chicago set a new record of seventeen floors and 222 feet to the top floor in late 1889. Meanwhile the New York World Building, also known as the Pulitzer Building, was completed in 1890 with sixteen to twenty floors (depending on how it is measured) and was 309 feet high, setting a new height record.
This cluster of new-record skyscrapers can be linked to the panic of 1890. Also known as the Baring crisis, it involved the near insolvency of Barings Bank in London. The crisis was international in scope, but the most severe impact did not involve the US economy. It should be kept in mind that the United States was becoming the world economic powerhouse, transforming itself from a largely agricultural economy into a manufacturing and service economy. As farmers went to the cities they often took jobs not only in manufacturing, but also in service sectors, such as insurance and sewing machine salespersons. The service industries were a significant component of the demand for office space and hence skyscrapers.
The Manhattan Life Insurance Building was completed in 1894 with eighteen floors and 348 feet in height, setting a new record. Also completed at this time were the American Surety Building with twenty floors and 303 feet in 1895 and the Masonic Temple with nineteen floors and 302 feet in 1892, but they are not widely considered clear record-breaking skyscrapers. Nevertheless, this cluster of skyscraper construction coincided with the largest contraction in US history, culminating in the largest quarterly decline in real GNP in US history and included the panic of 1893, which is thought to have begun six years of double-digit unemployment, although those statistics are still open to debate among economic historians.
The Park Row Building was completed in 1899. It was twenty-six full floors and is at least 309 feet in height: if the three-story cupolas are included its height is 390 feet, which would make it the world’s then-tallest skyscraper. The opening of the building was preceded by the fourth-largest quarterly decline in real GNP over the period of 1875–1918.
The next skyscraper cluster took place between 1904 and 1909. This is the cycle where Lawrence begins his documentation of the Skyscraper Index. It included the Singer Building, which, at forty-seven floors and 612 total feet in height, became the world’s tallest skyscraper when completed in 1908. The Metropolitan Life Insurance Company Tower set another new record in 1909 with fifty floors and 700 total feet in height. Both projects were begun prior to the panic of 1907 and were reaching record heights when the panic occurred. The panic occurred at a time when seasonal factors relating to fall harvests coincided with cyclical factors in credit markets. It ignited in October when a bank regulated under the National Banking Act refused to clear funds for the Knickerbocker Trust Company, an unregulated bank. The result was widespread runs on banks and one of the sharpest downturns in US history. This episode is historically important and of continuing relevance because it is widely considered to be the key event that led to the passage of the Federal Reserve Act in 1913.
It is worth noting that the panic of 1907, like many nineteenth-century panics, is now widely considered to have been caused by the regulatory structure imposed by the National Banking Acts (1863 and 1864). According to Howden,David Howden, “A Pre-History of the Federal Reserve,” in The Fed at One Hundred: A Critical Review on the Federal Reserve System, edited by David Howden and Joseph T. Salerno (New York: Springer, 2014). the financial instability during this period was not the result of a lack of regulation or unfettered capitalism. According to Michael Bordo, Peter Rappoport, and Anna J. Schwartz,Michael D. Bordo, Peter Rappoport, and Anna J. Schwartz, “Money versus Credit Rationing: Evidence for the National Banking Era, 1880–1914,” in Strategic Factors in Nineteenth-Century American Economic Growth, edited by Claudia Goldin and Hugh Rockoff (Chicago: University of Chicago Press, 1992), p. 189. the National Banking Acts created a system that was “characterized by monetary and cyclical instability, four banking panics, frequent stock market crashes, and other financial disturbances.” The poor performance of the subsequently adopted Federal Reserve has led many economists to call into question the suitability of a central bank for solving the problems caused by the National Banking Acts.
The Woolworth Building was the world’s next record-breaking skyscraper in 1913. When completed, it stood fifty-seven floors and 792 feet tall. Lawrence saw the Woolworth Building as an exception to, or error in, his Skyscraper Index because there was no curse in the sense that there was no major economic crisis that coincided with the building. There is no famous panic or depression in the history textbooks. Therefore it seems like the Skyscraper Index failed in this case.
However, it would be wrong to consider the Woolworth Building as evidence against the Skyscraper Index. The Woolworth Building project was announced in March of 1910, but at first it was planned to be a modestly tall building. In November 1910 its projected height was increased, but it was still only slated to become the third-tallest building in the world. In January of 1911 the building was re-planned to become one of the tallest buildings in the world at 750 feet, but this figure was later raised still higher to more than 792 feet high.Sara Bradford Landau, and Carl W. Condit, Rise of the New York Skyscraper: 1865–1913 (New Haven, CT: Yale University Press, 1996), pp. 382–84. The opening ceremonies for the Woolworth Building were held on April 24, 1913, although it was not fully completed until later.Ibid., p. 390.
In fact, the US economy peaked and began to contract in the first quarter of 1913, ahead of opening ceremonies. The economy continued to contract until the fourth quarter of 1914. This contraction included the third-worst quarterly decline in real GNP between 1875 and 1918, and was worse than any quarterly performance between 1946 and 1983. KazaGreg Kaza, “Note: Wolverines, Razorbacks, and Skyscrapers,” Quarterly Journal of Austrian Economics 13, no. 4 (Winter 2010): 74–79. reports that the building’s opening ceremony occurred during a twenty-three-month-long contraction between January 1913 and December 1914. This would clearly qualify this period as a severe recession.
The only reason that American history textbooks do not refer to the depression of 1913 or something else was that World War I was already brewing in Europe and hostilities would break out in mid-1914. WWI was the largest conflagration in human history, resulting in over twenty million casualties of all types. However, in the United States the war created a tremendous increase in demand from Europe for US agricultural products, metal production, and armaments, as well as labor. This event singlehandedly provided stabilization for the American economy and pulled it into an expansion, not an ordinary recovery. While economic historians now know that World War II did not get America out of the Great Depression,Robert Higgs, “Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s,” Journal of Economy History 52, no. 1 (March 1992): 41–60. WWI appears to have prevented the United States from falling into one.
Therefore, it would seem that the Woolworth Building should not be viewed as an exception to or error in the Skyscraper Index. It was simply that World War I in Europe did not provide enough time for the economic slump in the United States to deepen and to justify a historical label such as the depression of 1913.
A reexamination pre-Index of the evidence suggests that the Skyscraper Index is an even better forecasting tool than first presented by Lawrence. First, we have shown that the skyscraper curse occurred several times in the late nineteenth century. Second, the only example of an error of the original Skyscraper Index, when the curse did not happen, has a simple explanation. Our examination of this early period also makes clear that the causes behind both skyscrapers reaching new heights and economic crises emerging are related to government intervention in credit markets.
The next cluster of the world’s tallest buildings occurred at the onset of the Great Depression. Three record-breaking skyscrapers were announced during the late 1920s, when the stock market boom was being matched by booms in residential and commercial construction, as well as in manufacturing. In May 1930, the skyscraper at 40 Wall Street (now the Trump Building) was completed at a height of seventy floors and 927 feet. This was followed by the Chrysler Building in 1930 at seventy-seven floors and a height of 899 feet (925 feet to the roof and 1,046 to the top of the spire). The Empire State Building was completed a year later in May 1931 at 102 floors and 1,224 feet. Clearly, there was a capital-oriented boom in the construction of ever-taller buildings before the Great Depression.
Economists have offered many different explanations for the Great Depression, and Robert LucasRobert E. Lucas, Jr., Models of Business Cycles (New York: Basil Blackwell, 1987). has even claimed that it defies explanation. What is clear is that there was a significant increase in the money stock between the founding of the Federal Reserve and the stock market crash, a significant restructuring in banking and bank regulation, a significant decline in the supply of money after the crash, despite the Fed’s best efforts to stop it,Joseph T. Salerno, “Money and Gold in the 1920s and 1930s: An Austrian View,” Freeman (October 1999): 31–40. Reprinted in Joseph T. Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2010), pp. 431–49. a significant number of bank failures, and a variety of other important factors that contributed to the initiation and duration of the depression, including the Smoot-Hawley tariff and President Hoover’s and President Roosevelt’s New Deal policies.Murray N. Rothbard, America’s Great Depression, 5th ed. (1963; Auburn, AL: Mises Institute, 2000).
It is also worth noting that Ben Bernanke,Ben S. Bernanke, Essays on the Great Depression (Princeton, NJ: Princeton University Press, 2004). Milton Friedman and Anna Schwartz,Milton Friedman, and Anna J. Schwartz, The Great Contraction, 1929–1933 (Princeton, NJ: Princeton University Press, 1965). and Murray RothbardRothbard, America’s Great Depression. all place the blame for the Great Depression on the Federal Reserve, but for different reasons. Bernanke believes the problem was that the Federal Reserve failed to bail out systemically important banks in the 1930s. Friedman and Schwartz believe the problem was that the Fed failed to prevent a drop in the stock of money in the 1930s. Rothbard, using ABCT, found the cause to be the Fed’s expansionary monetary policy in the 1920s. These three theories will be reexamined later in the book.
The next major cluster of skyscraper records occurred in the early 1970s. Once again the economy was coming off a strong and sustained boom in economic activity during the 1960s. At the peak of the 1960s boom, construction workers in New York and Chicago were busy building the next group of the world’s tallest buildings. They would break records set back in the early days of the Great Depression. The World Trade Center was completed in 1972 and opened in April 1973. Both of the Twin Towers were 110 floors, with 1 World Trade Center at 1,368 feet in height and 2 World Trade Center at 1,362 feet in height. Then in Chicago, the Sears Tower was completed in 1974, which also had 110 floors but reached a height of 1,450 feet.
The economic downturn of early 1970 marked the beginning of a slump more than a decade long with the then-rare confluences of high rates of both inflation and unemployment. The breakdown of the Bretton Woods monetary system, abandoning the last vestiges of the gold standard, wage and price controls, gasoline shortages, and several recessions occurred between 1970 and 1982. There were several straight months in the early 1980s where unemployment was double digits and interest rates exceeded 15 percent. The US stock market declined in value between 1970 and 1982 by an inflation-adjusted 50 percent. The skyscraper curse for this period is known as the stagflation of the 1970s. This indicates that there was a general depression in the US economy between 1970 and 1982. The experience thoroughly discredited the then-dominant Keynesian school of economics, at least temporarily.
The next skyscraper cycle ushered in the 1997 Asian financial crisis and the dot-com bubble. The Pacific Rim countries, such as Hong Kong, Malaysia, Singapore, Vietnam, and South Korea, experienced significant economic growth during the 1980s and 1990s. Japan was the region’s leading economy, but it was in recession for much of the 1990s. Observers named the smaller regional economies the Asian Tigers. They were considered miracle economies because they were strong and durable despite being small and volatile. The bubble in East Asia was rooted in technology and export manufacturing, but it was fueled by an expansion of money and credit, much of it foreign money seeking high returns for “investors without borders.” This influx of foreign-investment money led to large increases in domestic money supplies and bank lending.
The Petronas Towers were completed in Kuala Lumpur, the capital of Malaysia, setting a new record for the world’s tallest building. They are only eighty-eight floors, but 1,483 feet in height, which breaks the old record by 33 feet. The two Petronas Towers were completed just months before the skyscraper curse hit in mid-1997. It marked the beginning of the extreme drop in Malaysia’s stock market and those around the region, rapid depreciation of local currencies, and even widespread social unrest. Financial and economic problems spread to economies throughout the region, a phenomenon known as the Asian contagion or, more generally, the Asian financial crisis. The ensuing credit crunch increased bankruptcies and created panic-like conditions.
At the same time, with increased US interest rates and a stronger dollar, the United States became a more attractive investment environment relative to East Asia. Starting in early 1996 this began to hurt Asian exports into the United States. These events essentially transferred the tech bubble from Asia to the United States and to a lesser extent Singapore and Taiwan, which were initially insulated from the crisis.
The next record breaker’s planning began in 1997. Construction began in 1999 on Taipei 101 in Taiwan City, the capital of the Republic of China (a.k.a. Taiwan). The 101-floor building set a new world record if you go by the height of livable space of 1,671 feet. This height surpassed the Petronas Towers, and Taipei 101 became the first skyscraper to exceed one-half of a kilometer. The roof was completed in June 2003, but we are not sure when the new record was set. However, its construction closely paralleled the dot-com ∕ tech bubble’s bursting. This was the first skyscraper cycle to occur in the developing world and the first in which one record, the Petronas Towers, was broken at the beginning of a crisis and the other, Taipei 101, was completed at the end of the crisis — that is, the dot-com ∕ tech bubble. A wild card here is the tech bubble, which was essentially transferred from the Asian-contagion countries to the United States and non-Asian-contagion countries, such as Taiwan and Korea. Taipei 101 is the first addition to the Skyscraper Index after Lawrence.Andrew Lawrence, “The Skyscraper Index: Faulty Towers!” Property Report, January 15, 1999.
The next world-record-breaking skyscraper was the Burj Dubai tower, which began construction in 2004 in Dubai, in the United Arab Emirates. At this time, it was clear to me that in the United States there was what would come to be called the housing bubble. The tower set a new record in the summer of 2007 just as the housing bubble ended and a financial crisis started to become apparent. The building opened to the public in January 2010 in the depths of the financial crisis, with Dubai bankrupt and needing a multibillion-dollar bailout from a neighboring emirate. The bailout resulted in the name of the building being changed from the Burj Dubai to the Burj Khalifa tower. This is another addition to the Skyscraper Index after Lawrence.Ibid.
These skyscraper cycles reliably contain common features. A cycle begins with a long period of easy money and credit. This leads to an expansion of the economy and a boom in the stock market. In particular, the relatively easy availability of credit fuels a substantial increase in capital expenditures. Capital expenditures start to flow in the direction of new technologies, which in turn create new industries and transform existing industries. This is when the world’s tallest buildings are begun. At some point afterward there is a necessary reversal. Many things could initiate the reversal. The reversal often gives the appearance of panic and mass psychological disorder, but people are being scared by real things such as not meeting profit expectations and projections, increases in interest rates, and problems with meeting sales projections, controlling costs, and retrieving accounts receivable. Finally, unemployment increases, particularly in capital- and technology-intensive industries. While this analysis concentrates on the US economy, the impact of these crises often has international implications.
The skyscraper has many of the characteristic features that play critical roles in various business cycle theories. These features make skyscrapers an important marker of the twentieth century’s business cycles, that is, the recurring pattern of entrepreneurial errors in a boom phase that are later revealed during a bust phase to be malinvestments.
It would be very easy to dismiss the Skyscraper Index as a predictor of the business cycle, just as indicators and indexes of other major entrepreneurial advances like canals, railroads, and factories were. The twentieth century skyscraper replaced the factories and railroads, just as the information and service sectors have replaced heavy industry and manufacturing as the prominent sectors of the present US economy.
It should not be surprising that the skyscraper, an important manifestation of the twentieth-century business cycle and indicator of modern global capitalism and commerce, will itself be replaced in the same way by an unknown new capital and technologically intensive investment in the future.
This chapter has demonstrated that Lawrence’s Skyscraper Index can be extended backward and forward in time and that the one instance where the Skyscraper Index was thought to have failed because the skyscraper curse failed to materialize has a perfectly logical explanation. Next we turn our attention to the question of what makes the Skyscraper Index work.
It makes very little difference how new money is injected. — Scott Sumner, TheMoneyIllusion
In previous chapters, I described economic growth and development as a process whereby lowering time preferences leads to an accumulation of savings that are invested in more-roundabout production processes, which in turn increase future consumption possibilities, labor productivity, and wages and incomes.
We now turn our attention to what happens with an increase in the money supply, rather than an increase in savings. This is critically important. The mercantilist idea that increasing the money supply increases prosperity was exposed as an error centuries ago by Richard Cantillon.Richard Cantillon, Essai sur la Nature du Commerce en Général, translated and edited by Henry Higgs (1755; London: Cass, 1931), chap. 1. However, modern mainstream economists, including the monetarists, Keynesians of various sorts, and the now-fashionable market monetarists, fully embrace the idea that printing money is necessary for prosperity.
In fact, the major central banks of the world have embarked on an unprecedented policy of monetary expansion both before and after the financial crisis of 2008. These central banks are led by people with advanced degrees in “economics,” and they have large research staffs of people with PhDs in mainstream economics. The result is a world currency war whereby each currency is printed in an effort to implement an economic expansion by a beggar-thy-neighbor policy, another widely discredited idea.
The beggar-thy-neighbor policy involves printing money to reduce the value of your domestic currency vs. foreign currencies. Reducing the value of your currency reduces the relative price of your exports and makes foreign products relatively more expensive so that you increase exports and domestically produced goods and reduce imports. The problem is that you also increase the price of imports and decrease efficiency. Ultimately this policy does not work: in the end you are worse off.
What happens when the supply of money increases? One of the first to examine this question was Richard Cantillon, writing in the 1730s in the wake of the Mississippi and South Sea Bubbles. Murray Rothbard wrote that Cantillon should have the premier honor among economists:
The honor of being called the “father of modern economics” belongs, then, not to its usual recipient, Adam Smith, but to a gallicized Irish merchant, banker, and adventurer who wrote the first treatise on economics more than four decades before the publication of the Wealth of Nations. Richard Cantillon (c. early 1680s–1734) is one of the most fascinating characters in the history of social or economic thought.Murray N. Rothbard, Economic Thought before Adam Smith: An Austrian Perspective on the History of Economic Thought (Brookfield, VT: Edward Elgar, 1995), vol. 1, p. 345.
I have written elsewhere about looking at Cantillon’s contributions through a modern and contemporary lens.Mark Thornton, “Richard Cantillon and the Origins of Economic Theory,” Journal of Economics and Humane Studies 8, no. 1 (March 1998): 61–74.
The Essai sur la Nature du Commerce en Général was completed shortly before Cantillon was murdered in 1734. Due to French censorship laws it was not published until 1755, and under mysterious circumstances. The book was initially very influential. It is believed he wrote Essai to explain the Mississippi and South Sea Bubbles, but he ended up creating an entire theoretical apparatus and what we now call Cantillon effects.
Cantillon investigated several possible causes of an increase in the domestic money supply including money’s importation from foreign countries and the discovery of new gold and silver mines. His important insight was that the effect of this new money depended on who had control of this new money and where it was injected into the economy. New money has a disruptive impact on an economy and can cause what we now call the business cycle.
Mainstream economists typically limit the discussion of Cantillon effects to the redistribution of wealth that accompanies an increase in the money supply.Andreas Marquart, and Philipp Bagus, Blind Robbery! How the Fed, Banks, and Government Steal Our Money (Munich: FinanzBuch Verlag, 2016). The first recipients of the money experience an increase in wealth, while those who do not receive it experience a decrease in wealth.Mark Thornton, “Cantillon on the Cause of the Business Cycle,” Quarterly Journal of Austrian Economics 9, no. 3 (Fall 2006): 45–60. Rouanet provides extensive empirical evidence of the Cantillon effect in terms of changing the distribution of income.Louis Rouanet, “Monetary Policy, Asset Price Inflation and Inequality.” Master’s Thesis, School of Public Affairs, Institut d’Etudes Politiques de Paris, 2017. However, this redistribution of wealth is only the first step in Cantillon’s much deeper analysis of the effects of an increase in money.
For example, if the increased money came from new silver mines, then the money would be in the hands of the owners of the mines and the miners themselves. Cantillon speculated that these now-rich people would consume more meat and wine, instead of bread and beer. This would in turn increase the price of meat and wine and decrease the price of grain. As a result, these price changes would lead farmers to increase the land devoted to raising cattle and vineyards, rather than grain. These are structural changes to the economy, and obviously the mine owners and miners are better off. The peasants who lived on bread and beer would be worse off because the decreased production of grain would mean higher bread and beer prices. Cantillon further theorized that money flows, prices, and the structural changes that were built on them could be reversed and that various businesses would be ruined as a result.
Mainstream economists dismiss all of these real changes in an economy as first-round effects. They do not believe there are any important real-economy impacts from an increase in the money supply, and if minor alterations did occur, it would only lead to temporary, inconsequential changes in the structure of production and income distribution.
To emphasize the importance of where the new money is injected into an economy, Cantillon noted that if the new money came into the hands of entrepreneurs, the rate of interest would fall, but if the new money came into the hands of consumers, the rate of interest would rise. If entrepreneurs found themselves with twice the amount of money they previously had, then they would have less demand for loans to finance their purchases of raw materials and to pay their labor. Therefore the rate of interest would be lower. If instead the new money were to double the amount of money that consumers possessed, then they would increase their purchases of goods. This would cause entrepreneurs to borrow more in order to supply the increased demand for goods, which would result in a higher interest rate. Either channel of increased money would put upward pressures on prices. In both cases, the group that receives the money first benefits, while those who receive it later, or not at all, are harmed by the higher prices.
Furthermore, Cantillon was the first to develop the theory of the price-specie-flow mechanism. This theory shows that a country that receives a bounty of new money will eventually experience higher prices. Some types of goods can be produced either domestically or imported from other countries. As the new money causes domestic prices to rise, there is an increased tendency for people to buy imported goods, and therefore money is sent to other countries. In this way, Cantillon showed that domestic industries that benefit and expand because of the increased supply of money will eventually be ruined because their expanded capacity will no longer be profitable in the face of low-priced foreign competition.
The general form of a Cantillon effect is that there is increased money coming into an economy from somewhere. The first recipients benefit. They spend it according to their preferences, and this causes certain prices to go up. The sellers of those goods benefit from the new money, while others who only face higher prices are hurt. Entrepreneurs respond to the higher prices by increasing their capacity to produce those goods by acquiring specific capital goods, raw materials, and labor. As the economy moves toward monetary equilibrium, the industry-specific capital goods are exposed as unprofitable, and if it is difficult to repurpose them for alternative uses, the adjustment process threatens those entrepreneurs with bankruptcy. The main point of Cantillon’s broader analysis is that changes in money result in changes in relative prices, which will change production plans and result in a different pattern of fixed investment such that new money changes the real economy and results in winners and losers.
Cantillon’s analysis regarding injection of new money has been adopted and extended by Ludwig von Mises and F. A. Hayek as a foundation of Austrian business cycle theory (ABCT). In the modern theory the increase in the money supply is usually restricted to an expansion of bank reserves by the central bank and an expansion of bank loans. In ABCT, this reduces the interest rate below the natural rate and initiates a boom in the prices of capital goods as well as company stocks and real estate. This, in turn, leads to the production of fixed capital goods that will later be revealed as malinvestments, in turn leading to bankruptcies, if not a skyscraper curse.
Money makes possible the good things in life: our ability to trade with one another and the ability to form groups to work for beneficial purposes, as well as saving, investing, economic growth, and development. Without some form of money, advanced society would not be possible. However, as we saw in the previous chapters, increases in the supply of money, which mainstream economists now view as indispensable, are really the source of many evils of economic life.
Increases in the supply of money result in higher consumer prices, a process now known as inflation. This means that many people with jobs suffer diminishing purchasing power of their wages over time. Economic historians have long agreed that such inflation is the enemy of labor. Free market monies, such as gold and silver, typically increase in value over time, which is beneficial for wage labor and encourages work and saving, as the purchasing power of wages and savings tends to increase over time.
Increasing the money supply causes an unnatural redistribution of wealth. People who receive the money first become wealthier because they spend the money before prices have risen. People who receive the money later or not at all become poorer because they pay the higher prices. In the case of money coming from the Federal Reserve, the biggest winners are the US government; its large contractors, such as weapons manufacturers, big banks, and Wall Street. As a result, the financial sector of the US economy has grown enormously and economic inequality, measured in terms of income and wealth, has increased dramatically since the United States went completely off the gold standard in 1971. The financial-services sector has grown from about 4 percent of the US economy then to over 8 percent now. Thomas PikettyThomas Piketty, Capital in the Twenty-First Century (Cambridge, MA: Harvard University Press, 2014). has famously shown that inequality of income and wealth has increased greatly in the United States and elsewhere. However, the entire increase in inequality has come after 1970 and the abolition of the Bretton Woods gold standard. The period beforehand, when we were on the gold standard, is one of increasing equality.
The big losers receive the money after prices have already risen. The losers would include private-sector workers and people on pensions or fixed income — in other words, the labor class. Inflation also harms savers and bond investors, as well as taxpayers who find themselves in higher tax brackets when wages catch up with price inflation. Simply put, paraphrasing Senator Phil Gramm of Texas, the people pulling the wagon are harmed and reduced in number, while the people sitting in the wagon benefit and increase in number.
Finally, inflating the money supply causes the business cycle, and this is the least well-understood aspect of the Fed’s increasing of the money supply. It is not just natural swings in the economy; it is artificial, squanders resources, and ruins lives. This will be illustrated with the case of skyscraper construction.
Inflating the money supply is directly connected to interest rate manipulation. When the Fed buys government bonds from banks, it gives them dollars, which they can reinvest in more government bonds, mortgages, commercial loans, and consumer loans. This process artificially reduces interest rates. It also completes the movement of government bonds from the US Treasury, to the big banks, to the balance sheet of the Fed. It can sit there until it comes due, at which time the Fed can purchase more government bonds. The Fed is required to return any leftover interest income from these bonds to the US Treasury, so this process is the equivalent of an interest-free loan. Also, as monetary expansion turns into price inflation and lowers the value of the dollar, it effectively reduces the value of the national debt, a process referred to as monetizing the national debt. It is a convoluted process, but you can see why those who benefit do not want to reform it. It is quite a racket for the politicians, the big banks, and their highly paid facilitators at the Fed. This is the process that brings about artificial gyrations in interest rates and creates Cantillon effects and business cycles.
The Cantillon effects that we can see in record-breaking skyscrapers are symptomatic of what is going on in the economy; it is just more difficult to point to some particular project or new technology and claim that it is a malinvestment caused by the Federal Reserve and artificially low interest rates. So remember, skyscrapers themselves do not cause business cycles, the Fed does.
Many people consider the skyscraper a form of art, but their construction is essentially a business that must respond to incentives and constraints. Therefore skyscraper construction can be expected to follow closely even small changes in relative prices. In reevaluating the early skyscraper artistically, Ada Louise HuxtableAda Louise Huxtable, The Tall Building Artistically Reconsidered: The Search for a Skyscraper Style (Berkeley: University of California Press, 1992). noted:
Essentially, the early skyscraper was an economic phenomenon in which business was the engine that drove innovation. The patron was the investment banker and the muse was cost-efficiency. Design was tied to the business equation, and style was secondary to the primary factors of investment and use. … The priorities of the men who put up these buildings were economy, efficiency, size, and speed.
That is not to say that the early skyscrapers were without artistic merit, or that later structures failed to improve artistically; quite the contrary. Nevertheless, post-WWI skyscrapers continued to emphasize profits and technology. The early skyscraper drew from existing technology and was considered an engine of innovation. Even in modern times, design continues to grow and evolve, but for Helmut Jahn,Quoted in ibid., p. 117. the “structural rationale for such a tall structure is technically and economically inescapable.” For Huxtable,Ibid., p. 105. “Architecture simply doesn’t count. … With pitifully few exceptions in the past, New York’s skyscrapers have never reached for anything but money.” Art, technology, government regulations, and even ego must be considered factors, but the skyscraper is essentially captive to economic forces and motives. Therefore when architects are asked what makes for the super skyscraper, economic forces are considered preeminent. Psychological factors related to ego are created in the credit driven boom.
In this context it is important to remember that changes in the price of land, building materials, and the interest rate will have important implications for skyscraper construction. Changes in the rate of interest have three separate Cantillon effects on skyscrapers. All three effects are reinforcing, and all three effects are interconnected to the transformation of the economy toward more roundabout production processes. When the rate of interest is artificially reduced, all three effects contribute to the desire to build taller structures. The world’s tallest buildings are generally built when the interest rate is reduced substantially below the natural rate for a sustained period of time. In contrast, when the interest rate is forced above the natural rate the economic effects reduce the value of existing structures and the demand for tall buildings. Construction can come to a complete standstill.
The first Cantillon effect is the impact of the rate of interest on the price of land. The most obvious cause of this result is that lower interest rates reduce the opportunity cost of borrowing to buy the land and to build structures. As a result, owners of land and real estate experience an increase in their wealth. This relationship is confirmed by Jeremy Atack and Robert Margo,Jeremy Atack, and Robert A. Margo, “‘Location, Location, Location!’ The Market for Vacant Urban Land: New York 1835–1900.” NBER Historical Paper 91, National Bureau of Economic Research (Cambridge, MA, August, 1996). who examined the market for land in New York City during the nineteenth century. Their evidence suggests that land values tended to increase during deflationary periods, when interest rates tend to be low, but less so during inflationary periods, when interest rates tend to be higher because of the inflation premium in interest rates. Paul CwikPaul Cwik, “Austrian Business Cycle Theory: Corporate Finance Point of View,” Quarterly Journal of Austrian Economics 11, no. 1 (2008): 60–68. demonstrates that the interest rate has an impact on the net present value of working capital and longer-lived fixed capital. As a casual observation, when interest rates are artificially low, you tend to see more “land for sale” signs along roads and interstate highways because land prices are higher in general.
A lower rate of interest also tends to increase the value of land, because the interest rate is used by entrepreneurs as a proxy for the discount rate. In evaluating any investment project, entrepreneurs estimate the net present value of a project by looking at the projected income stream from the investment over a long period of time and adjusting it for interest payments over time. The income in the first year does not have to be discounted much at all, that is, just one year’s interest expense, but that same income in year twenty-five has to be discounted by twenty-five years of interest expenses and may be worth nothing in terms of net present value. Net present value of an income stream has to exceed risk-adjusted cost of an investment for the project to be undertaken. High interest rates lead to heavy discounting of income streams, whereas low interest rates lead to less significant discounting, which makes long-term projects seem relatively more profitable.
For example, consider an investment project that is expected to produce $1 million in income above operating costs per year for ten years. In the tenth year of operation, if the discount rate is 4 percent, the calculated net present value of that year’s $1 million net income is $675,000. However if the discount rate is 8 percent then the calculated net present value of that year’s income is only $463,000.
From this we can see that land values rise because lower rates of interest reduce the opportunity cost, or full price, of owning land and drive up the net present value of income streams from using land. Treating the rate of interest as the cause, a reduction in the interest rate will increase the demand for land and result in an increase in land prices. The impact of lower discount rates will tend to favor longer-term investment projects using land, such as skyscrapers.
It has been often said that the three most important things about real estate are location, location, and location. When the rate of interest is falling, the land best suited for the production of the longer-term, more capital-intensive, and more roundabout methods of production will increase in price relative to land better suited for shorter-term, more direct methods of production. As land prices rise, the yield required from any piece of land to make ownership of it profitable must also rise. Combined with a lower cost of capital brought about by a lower rate of interest, land owners will seek to build more-capital-intensive structures, and at the margin, this will cause land to be put to alternative uses.
In the central business district this means more-intensive use of land and thus taller buildings. Higher prices for land reduce the ratio of the per-floor cost of tall vs. short buildings and thus create the incentive to build taller buildings to spread the land cost over a larger number of floors and more leasable space. Thus, higher land prices lead to taller buildings. In my hometown there are a variety of one- and two-story structures currently being demolished to make way for the construction of multifloor structures. These projects are stimulated by artificially low interest rates and the search for yield on investment funds. In this manner, the height aspect of the projects is driven by land prices.
The second Cantillon effect from lower rates of interest is the impact on the size of firms. A lower cost of capital encourages firms to grow in size and to take advantage of economies of scale, such as the example of the dairy industry in transition. Here, companies that expand based on artificially low interest rates benefit, at least temporarily, at the expense of companies that do not and exit the industry. As part of this larger-scale, more roundabout production process, firms develop central offices or headquarters for their accounting, management, marketing, human resources, and product-development departments. This increases the demand for office space in central business districts. This demand in turn raises rents and encourages the construction of taller office buildings within the central business district.The phenomenon of firms growing in size and scope in response to artificially low interest rates can be seen in the history of merger-and-acquisition waves. Mergers between two firms occur when both firms believe they can profit from combining their operations. Acquisitions and takeovers occur when one firm believes it can manage the combined assets of the firms in a more profitable manner. Lower interest rates reduce the cost of the capital to buy out investors of the other firm. Mergers and acquisitions have occurred in clusters or waves during periods of low interest rates and easy credit conditions (the boom), and because they often start operating as a united company during the bust, their record of success has not been great.
SaraviaJimmy A. Saravia, “Merger Waves and the Austrian Business Cycle Theory,” Quarterly Journal of Austrian Economics 17, no. 2 (Summer 2014): 179–96. shows that waves of mergers and acquisitions that have been experienced in the past are consistent with Austrian business cycle theory (ABCT). Not only do low interest rates help finance mergers and especially acquisitions, but the demand for such business deals is a reflection of the “resource crunch” of ABCT as shown in the previous example of the expansion of the advanced computer-chip industry. Ekelund, Ford, and ThorntonRobert B. Ekelund, George Ford, and Mark Thornton, “The Measurement of Merger Delay in Regulated and Restructuring Industries,” Applied Economics Letters 8, no. 8 (2001): 535–37. show that when mergers are delayed by government “red tape,” the resulting acquisitions and mergers tend to be unprofitable because they are often completed during an economic downturn. ThorntonMark Thornton, “Review of The Synergy Trap: How Companies Lose the Acquisition Game, by Mark L. Sirower,” Quarterly Journal of Austrian Economics 2, no. 1 (Spring 1999): 85–86. has furthered the discussion of why so many mergers and acquisitions turn out to be miscalculations.
The third Cantillon effect is the impact of interest rates on the technology of constructing record-tall buildings. Record-breaking skyscrapers require innovation and new technology in order to be profitable. Buildings that reach new heights pose numerous engineering and economic problems relating to such issues as building a sufficiently strong foundation, ventilation, heating, cooling, lighting, transportation (e.g., elevators, stairs, and parking), communication, electrical power, plumbing, fire protection, and security systems, as well as wind resistance, structural integrity, and even window cleaning. There are also a host of public issues connected with increases in employment density brought about by tall structures, such as transportation congestion and environmental concerns. For example, Sukkoo KimSukkoo Kim, “The Reconstruction of the American Urban Landscape in the Twentieth Century,” NBER Working Paper 8857, National Bureau of Economic Research (Cambridge, MA, April 2002). showed how increases in skyscraper-building and, in particular, improvements in skyscraper technology lead to increases in employment density. Here, advanced technology businesses benefit at the expense of incumbent technology businesses.
Beyond the mere technology it takes to build the world’s tallest building, every vertical beam, tube, cable, pipe, or shaft in a building takes away from leasable space on each floor built, and the more floors in the structure, the greater the required capacity of each system in the building, whether it is plumbing, ventilation, or elevators. So designers, architects, and building contractors cannot simply increase the size of each system to increase capacity. They must come up with new, more efficient systems to reach record heights. Consequently, there is a tremendous desire to innovate with technology in order to conserve on the size of these building systems or to increase the capacity of those systems. Therefore, as the height of construction rises, input suppliers must go back to the drawing board and reinvent themselves, their products, and their production processes.
M. Ali and Kyoung Sun MoonM. Ali, and Kyoung Sun Moon, “Structural Developments in Tall Building: Current Trends and Future Prospects,” Architectural Science Review 50, no. 3 (September 2007): 205–23. describe how designers and engineers have a tremendous need to innovate to conserve on the requirements of building systems. For example, one elevator shaft with a floor size of 2×2 meters would take up the space equivalent of ten efficiency-sized apartments in a hundred-floor building. At standard speeds it would take about ten minutes to get to the top floor of the Burj Khalifa tower, plus the time it took for the elevator to arrive on your floor and any additional stops on the way to your destination. AmesNick Ames, “Elevator Installation Prep Begins at Kingdom Tower,” ConstructionWeekOnline.com, May 10, 2015. reports that KONE Corporation engineers have created a new elevator cable that weighs less than 7 percent of the weight of traditional steel cables, which each weigh over twenty tons for a 400-meter-high building. Obviously, a twenty-ton cable would require an enormous amount of power to operate. Therefore, as building heights rise, technology must be advanced to conserve on the building systems’ footprint.
Another example of this type of technological effect is in heating and cooling systems for especially tall skyscrapers. Record-breaking skyscrapers require a tremendous capacity for heating and cooling; and traditionally, hot and cool air or water would have to be pumped long distances, which is both inefficient and requires a great deal of space for all the ductwork and plumbing. A recent solution to this problem is a system called variable-refrigerant-flow zoning and split-ductless systems. Instead of massive amounts of air or water transported throughout a building, only the refrigerant — for example, Freon — is moved to each zone. It is transported in small copper tubing rather than bulky ductwork or water pipes, which take up horizontal space between each floor as well as vertical space. Each zone can have its own temperature, and the flow of refrigerant is variable according to the needs, rather than just on and off. The total amount of equipment is less, it is easier to maintain, and it is said to be 25 percent more energy efficient. Surely this is a great invention, but one that would not have come along as early as it did in the age of the mega-skyscraper. In other words, enormous amounts of resources were expended to obtain small gains in efficiency due to the artificially high demand to build very tall skyscrapers. When the next economic crisis comes, the demand for these advanced technologies could collapse because either no one is building such skyscrapers or they are only building much smaller buildings.
Construction systems must also be reinvented to tackle new record-breaking construction projects. For example, pumping concrete higher to build taller structures requires innovation in concrete-pumping technology; the same can be said for cranes and moving laborers to and from their worksite on the building. Again, in the economic crisis that follows, these systems and all the capital combinations that support them could either go unused or used at greatly diminished levels.
All three Cantillon effects resulting from lower rates of interest are interrelated and reinforcing. All three are generally recognized by people involved in the construction of large office buildings including architects, bankers, contractors, design specialists, engineers, entrepreneurs, government regulators, often the tenants themselves, and finance specialists such as bond dealers.
Higher interest rates discourage the construction of taller buildings and of construction in general because capital is scarcer and land is less in demand and available at lower prices. Higher interest rates also create financial difficulties for the owners of existing structures because of the decreased demand for office space and condos. Companies engaged in construction and their suppliers face a decrease in the demand for their services, the impact of which falls hardest on those firms that specialize in the production of the tallest buildings and the suppliers of the specialized construction systems and building systems for ultrahigh construction.
In other words, the technologies and industrial capacities that were induced by the artificially low interest rates are now greatly incapacitated and mostly idle. The buildings themselves are likely to have excess capacity, with too few tenants and lower-than-expected leasing rates.
The interest rate is what makes the construction business, in part, such a speculative business. Homebuilders build spec houses and face the risk of finding a buyer at a profitable price. Developers build speculative office buildings, which in contrast to many corporate headquarters are investments that rely on an uncertain flow of rental income. Separating the winners from the losers is not so much a matter of greed as it is a matter of time and calculation. Skyscraper expert Carol Willis explained the difference between normal times and boom times:
In normal times, when costs of land, materials, and construction are predictable, developers use well-tested formulas to estimate the economics of a project. These calculations are based on the concept of the capitalization of net income. This value takes into account the net income for thirty or forty years. … [T]he conventional market formulas and the concept of economic height were widely known and followed in the industry. Most speculative building was not risky, but reserved in its calculations and highly responsive to market desires.Carol Willis, Form Follows Finance: Skyscrapers and Skylines in New York and Chicago (New York: Princeton Architectural Press, 1995), p. 157.
All of these normal calculations that help ensure profit and avoid loss are not, however, reliable during the boom phase of the business cycle.
In booms, the so-called rational basis of land values is disregarded, and the answer to the question “What is the value of land?” becomes “Whatever someone is willing to pay.” Some speculators estimate value on new assumptions of higher rents; others simply plan to turn a property for a quick profit. … But due to the cyclical character of the real estate industry, the timing of a project is crucial to its success, and the amount a property reaps in rents or sale depends on when in a cycle it is completed or comes onto the market.Ibid., pp. 157–58.
Building the world’s tallest building has been a matter of particularly bad timing by entrepreneurs, and even if they were able to successfully steal away enough tenants from the remaining pool of renters, the economic problem for society is that valuable resources are lost in the process of constructing buildings that are bad investments and underutilized. See, Patric Hendershott and Edward Kane,Patric H. Hendershott, and Edward J. Kane, “Causes and Consequences of the 1980s Commercial Construction Boom,” Journal of Applied Corporate Finance 5, no. 1 (Spring 1992): 68. who estimated that there was more than $130 billion wasted in the commercial construction boom of the 1980s. The Empire State Building was nicknamed the Empty State Building because of its high vacancy rates until after World War II.
However, it is not the entrepreneur’s formula that is at fault, but a system-wide failure that has occurred periodically throughout the twentieth century and before, and is known as the business cycle. HoytHomer Hoyt, One Hundred Years of Land Values in Chicago: The Relationship of the Growth of Chicago to the Rise in Its Land Values, 1830–1933 (Chicago: University of Chicago Press, 1933). found the building cycle was a “motion of a definite order” lasting eighteen years, on average, from peak to peak. Willis raised the key issue as it relates to skyscrapers:
Indeed, a key question about cycles is, if their pattern is so predictable, why don’t people foresee the inevitable bust? This conundrum can perhaps be answered by looking more closely at the dynamics of speculation and at a typical skyscraper development.
Hoyt suggested that the cycle is long enough for people to forget the lessons of the previous cycle and thus not be able to apply it to the next cycle. However, the building cycle is much more volatile and unpredictable than this eighteen-year average would suggest. Together with the impact of local economic conditions and government intervention, the combination of factors blurs any usefulness of the simple knowledge that business cycles exist and have an average duration. Indeed, the people who experience one business cycle are often not even the same as the people who experience the next cycle. As Willis noted:
After the collapse of an inflated market, it is easy to look back on the grave errors of judgment that preceded a crash; yet the basic indicators of the twenties economy seemed to promise unimpeded growth. Pent-up demand for office space after World War I, the expanding numbers of the white-collar workforce, and the increasing per-person average for office space all fueled the building industry. Each year, the summaries of annual construction figures reported record numbers.Willis, Form Follows Finance, p. 159.
Willis did correctly identify that “easy financing underlie[s] all booms,” but this does not answer her conundrum, because easy financing and low interest rates are also at the heart of genuine economic growth. The entrepreneur’s problem is that profit calculations cannot show for sure whether interest rates will remain low and projects will succeed (i.e., economic growth), or rates will rise and projects will fail (i.e., the business cycle). Furthermore, it should be made clear that in ABCT, low interest rates and “easy financing” are terms defined not on the basis of their magnitudes, but in relation to their natural rates, which of course are not calculable outside of a free market.
The notion that a record-breaking skyscraper can cause economic crises sounds ridiculous, and it is very much absurd. There is no causal relations between skyscraper construction and the skyscraper curse.
The causality that does exist is between artificially low interest rates causing both record-breaking skyscrapers and economic crises. Artificially low rates also cause distortions throughout the economy. Very low rates over extended periods of time are what bring about the record skyscrapers and the economic crises. The skyscraper itself is merely an identifiable manifestation of what is happening throughout the economy.
There are distortions, also known as Cantillon effects, directly tied to the skyscraper, such as what happened with the new lightweight elevator cable. Resources had to be diverted to research and development of the new elevator cable from other investment possibilities. A new production facility and production process had to be designed to produce the cable in a profitable fashion. Distribution could probably take place with existing company facilities, but certainly the marketing aspect of the product would have to be built from scratch. When the economic crisis comes, all these resources could have very low value. What happened to the elevator cable company is taking place in all areas of the economy, although it is not universal.
This type of distortion is occurring throughout the economy as entrepreneurs succumb to the lure of artificially low interest rates and embark on investments in more roundabout and advanced production techniques. These investments will later be discovered to be malinvestments in what has been described as a cluster of entrepreneurial errors, a phrase first used by British economist Lionel RobbinsLionel Robbins, The Great Depression (London: Macmillan, 1934). in his description of the Great Depression of the 1930s.
Much of the interest in the Skyscraper Index can be linked to its ability to forecast the business cycle and to predict the business cycle. In my view, its primary and best use is not to be able to predict the future, but to be able to describe the types of real changes that occur in an economy exposed to artificially low interest rates. Those changes can then be linked to the troubles we experience in the economic crises that follow. Thus, it helps us to understand the business cycle. Unfortunately, many economists ignore the business cycle or do not believe in economic causes of the business cycle. I am afraid that if this situation is not rectified soon, Karl Marx might turn out to be right about business cycles. He argued that business cycles will intensify over time and bring about the demise of capitalism.
In what follows I review an editorial from The Economist“Towers of Babel: Is There Such a Thing as the Skyscraper Curse?” March 28, 2015. that was published March 28, 2015, under the title “Towers of Babel.” The editorial was based on an academic article published by three Rutgers University economists. Unfortunately, the editorial staff of The Economist accepted the wrong, naïve understanding of cause and effect when it comes to skyscrapers. They did not refer to me by name in the editorial, but they did reference my 2005 article as a reference for what, in their minds, is the wrong point of view.
The editorial begins by noting that the world is in a major skyscraper boom and that such booms have often been an ominous signal of tough economic times ahead — the skyscraper curse. The Economist had long reported on and agreed with the Skyscraper Index,Jason Barr, “Skyscrapers and the Skyline: Manhattan, 1865–2004,” Real Estate Economics 38, no. 3 (2010): 567–97. but they were no longer sure:
Does this frenzy of building augur badly for the world economy? Various academics and pundits, many of them cited by The Economist, have long argued as much, but new research casts doubt on it.Ibid.
They then explain the economics of skyscrapers, noting that taller buildings mean more potential revenues. However, they correctly note that the marginal costs of construction also increase with taller buildings. This part of the editorial is a great capsule summary of my 2005 paper, although the role of the interest rate is not introduced. They then mention Jason Barr’s 2010 article, which seems to provide some support for the Skyscraper Index.
Then they turn to the paper, “The Skyscraper Curse: Separating Myth from Reality.”Jason Barr, Bruce Mizrach, and Kusam Mundra, “Skyscraper Height and the Business Cycle: Separating Myth from Reality,” Applied Economics 47, no. 2 (January 2015): 148–60. Two sets of evidence from that paper are presented. The first set examined the question of why the biggest towers are built near the peak of the business cycle and whether that relationship could help you predict changes in Gross Domestic Product (GDP). They found that the time between announcement date of record setters and business cycle peaks is very long and that only half of the skyscraper opening dates occurred during a downward phase of the business cycle: “In other words, you cannot accurately forecast a recession or financial panic by looking at either the announcement date or the completion date of the world’s tallest building.”
The problem with this is that no one familiar with the Skyscraper Index would use the announcement dates and completion dates as a consistent forecasting tool. The World Trade Center towers were announced in the early 1960s, nearly a decade before the first tower opened. Also, many announced record-breaking buildings never get off the drawing board or off the ground, or are not built as planned. The better dating method for identifying the existence of a bubble and future trouble would be to look at groundbreaking ceremonies. Such ceremonies are an indication that plans have been approved, financing and permits have been obtained, land has been purchased, and any necessary testing has been started or completed.
When looking for signs of trouble — that is, the skyscraper curse — a better date would be when the project has actually beaten the old record, or is approaching that point. The Burj Khalifa tower broke the old record in the summer of 2007, when economic conditions seemed good, but it was two and half years before it was completed and opened to the public. As a word of caution, none of these dating processes are some kind of exact, precise, or magical process; they are just rules of thumb based on experience. However, by using announcement and completion dates, the Barr, Mizrach, and Mundra study exaggerated the amount of error that actually exists. Plus, as The Economist notes, it is based on a very small sample size of fourteen. The role of clusters or cycles of record-breaking skyscrapers should also not be ignored.
To rectify the small sample size, the study’s authors turned to a second set of data that includes the tallest building completed each year in four countries, which expanded the number of data points to 311. They compared data on tall but not necessarily record-breaking buildings to changes in local per capita GDP, not severe economic crises. As a result, they found that skyscraper construction and per capita GDP were cointegrated. When two time-series data sets are cointegrated it means that they move, in general, in the same direction and are thought to be the result of the same causal forces. For example, national income and national consumption will tend to move in the same direction, with small variations. You can think of a dog owner walking the dog on a leash as being cointegrated. The dog might be out front and then move behind the owner, but they are both following the same basic path. The fact that Barr, Mizrach, and Mundra found that skyscrapers and GDP are cointegrated means the two data sets move in the same general direction and implies, in other words, that skyscraper construction does not cause the business cycle, and that both statistics are caused by some other factor or factors.
One major problem with this data is that the Skyscraper Index is not based on general skyscraper construction, but instead on record-breaking skyscrapers. As we have seen before, because of the technology requirements and economic constraints, building two, hundred-story buildings is not the same thing as building one 200-story building. Another problem is that the skyscraper curse involves an economic crisis, not the ordinary ebbs and flows of the typical business cycle.
But let us ignore these fundamental problems with their evidence. The evidence that skyscraper construction and per capita GDP are cointegrated and move together with a common cause is exactly what is predicted by the Skyscraper Index! Both statistics move together and have the common cause of artificially low interest rates. The Skyscraper Index tells us that artificially low interest rates cause record-breaking skyscrapers, usually in clusters, as well as a bubble in the economy and eventually an economic crisis — the skyscraper curse. In other words, none of their evidence undermines the Skyscraper Index; it supports it.
Stunned by the editorial, I wrote The Economist a letter to the editor to try to clarify the meaning and status of the Skyscraper Index. That letter of March 30, 2015, is reprinted here verbatim:
Dear Editor of The Economist:
Thank you for discussing my research and referencing my journal article from the Quarterly Journal of Austrian Economics. (“Is there such a thing as a skyscraper curse?” March 28th) I would note that Mr. Barr, Bruce Mizrach and Kusum Mundra’s research actually supports my thesis that misaligned interest rates cause both record setting skyscrapers and economic crisis. The fact that skyscraper height and GDP are cointegrated is no surprise and actually supports the case for a skyscraper curse. Also, I claim no precision with respect to the exact timing of events, especially with respect to “announcements” and “completions.” Groundbreaking and record achieving dates are actually more relevant, yet are still imprecise. They say a picture is worth a 1000 words and I think you’re graphic of the timing of record setting skyscrapers and economic crisis says it all.
Mark Thornton, PhD.Senior Fellow (economist)Ludwig von Mises InstituteAuburn, AL 36830 (USA)
Unfortunately, they did not print my letter. I was contacted more than three months later and they explained that my letter had been misplaced.
Based on discussions with Lucas Engelhardt, we decided to go back to the original academic journal article and reexamine their findings. Based on that examination, we determined that a comment should be written on the article. Once a common practice, the comment is not nearly as common today, but it still exists at many academic economic journals, including Applied Economics, where the original Barr, Mizrach, and Mundra article was published. Originally, we thought the title of the comment should be “Skyscraper Height and the Business Cycle: Separating Data from Reality,” but we chose instead to go for the conventional approach. The comment is reproduced below.
Skyscraper Height and the Business Cycle: Separating Myth from Reality, a Comment In a recent paper in this journal (Applied Economics), Jason Barr, Bruce Mizrach and Kusum Mundra test for the existence of a Skyscraper Curse, which Lawrence (1999) states is the “eerie correlation” between the building of record-breaking skyscrapers and economic crisis. Thornton (2005) shows the theoretical connections between record-breaking skyscrapers and economic crisis. However, the evidence that Barr et al. (2015) presents brings into doubt the existence of the Skyscraper Curse. Based on their evidence the Economist declared: “you cannot accurately forecast a recession or financial panic by looking at either the announcement or the completion dates of the world’s tallest building.”
Here we reexamine Barr et al. (2015) and come to a completely different conclusion. Their evidence does not refute the Skyscraper Curse and most of the more rigorous evidence actually supports it. With the Skyscraper Curse, output and height should be cointegrated and output should Granger cause height. Their evidence here is not only strong, but is more broadly applicable beyond the more narrow issue of record-breaking skyscrapers and once-in-a-lifetime economic crises.
Barr et al. (2015) use Granger causality and cointegration tests to analyze the relationship between skyscraper height and output. They use annual time series data for the tallest building completed each year and real per capita GDP for the United States, Canada, China, and Hong Kong as their measure for output. Their evidence shows that both height and output have a common trend indicating a cointegrated relationship. Granger causality tests show that output causes height, but height does not cause output.
The evidence from Granger causality and cointegration tests actually supports the theory of the Skyscraper Curse. No one believes that simply building a record-breaking skyscraper actually causes an economic crisis. The record-breaking skyscraper is more of an illustration of the types of microeconomic and technical changes to the overall structures of production that take place throughout the economy in response to artificially low interest rates.
Thornton (2005) clearly describes the Skyscraper Curse theory in terms of a third causal factor, artificially low interest rates, that cause both record-setting skyscrapers and unsustainable economic booms and, eventually, economic crisis. There have been several studies such as Barr (2012) that have suggested that such a third factor is responsible for the building of record-setting skyscrapers, such as builder competition, social status, and ego. However, in contrast to these psychological factors, artificially low interest rates provide an economic explanation for 1. Record-breaking skyscrapers, 2. The boom-bust cycle, and 3. Changes in social psychology. Therefore the results of the Granger causality and cointegration tests are completely in line with the expectations of Thornton’s (2005) model.
In contrast to their Granger causality and cointegration test results, the evidence in Table 1 of Barr et al. (2015) does strongly bring into question the existence of the Skyscraper Curse. They use the dates that record-setting skyscrapers were publically announced and the dates that those buildings were opened to the public and find little correlation with either of these dates and the business cycle.
However, there are multiple problems with their evidence. First, neither of these dates would be expected to be well correlated with the business cycle and especially with major economic crises, except in one sense. Announcement dates should generally occur during the boom phase of the cycle. They did find that 10 of 14 announcements did occur correctly in an expansion and 1 occurred at the very peak of the cycle. The 3 remainders occur because the “nearest US peak” is arbitrarily used, placing the 3 announcement dates after a previous peak. Additionally, using NBER peak and trough dates is not a true test of the Skyscraper Curse which is restricted to major economic crises.
Thornton (2014) suggests that announcement dates should be ignored and that instead, ground-breaking dates should be considered “skyscraper alerts” indicating that bubble-related investment opportunities exist, but danger is ahead. Furthermore, the date of record-completion, in the sense that the record-breaking height has been achieved, is a “skyscraper signal” suggesting that economic danger is imminent. Opening dates may be many months or even years in the future from record-completion dates and record-breakers often open in the midst of an economic crisis.
Barr et al. (2015) also downplay the Skyscraper Curse by noting that “the range of months between the announcement and peak is tremendous, varying from 0 to 45 months.” However, this variation is the result of using the announcement date so that, for example, the World Trade Towers was announced in January 1964, but the ground-breaking date for construction began in August 1968. They also use US cycle dating for two foreign records, Petronas Towers and Taipei 101. These record-breakers are normally connected to the Asian Financial Crisis of 1997–98 and also to the Tech Bubble-Bust (1997–2001), but these events bear little relationship with either the announcement or opening dates.
There remain several anomalies in Table 1. The Woolworth Building was announced in July of 1910 and opened in April 1913, but there is no economic crisis of note connected to it. However, the economy did peak and began contracting in the first quarter of 1913 and continued to contract until the fourth quarter of 1914. This contraction included the third worst quarterly decline in real GNP between 1875 and 1918, and was worse than any quarterly performance between 1946 and 1983. The founding of the Federal Reserve System in 1913 and the coming of World War I in Europe in 1914 provided stabilization for the American economy as exports to Europe soared. These 2 exogenous factors prevented the Woolworth Building from being associated with the Skyscraper Curse because the intervention of World War I reversed the deepening economic slump and prevented a historical label (e.g., “Depression of 1913–15”) from being created.
Table 1 also lists the Pulitzer (1890) and Manhattan Life (1894) buildings, which along with the Masonic Temple in Chicago (1892) and Auditorium Building (1889) represent a wave of record-breaking skyscrapers that preceded the beginning of the largest contraction in US history, culminating in the largest quarterly decline in real GNP in US history, which was then followed by the Panic of 1893 and 6 years of double-digit unemployment.
With these clarifications, 13 of the 14 buildings listed by Barr et al. (2015) come into agreement with the Skyscraper Curse model. The Park Row Building, which was announced in 1896 and opened in 1899 does not seem to fit the model, but is in synch with the emergence of the then new steel frame construction technology. If you take skyscraper waves and historical context into account, record-breaking skyscrapers are indeed associated with major economic crises and the Skyscraper Curse does add to our ability to foresee macroeconomic risks, even if the complexities of history prevent predictions of timing from being precise. We agree with Barr et al. (2015) and the Economist that the Skyscraper Index and its Curse is of little value in forecasting the normal ebb and flow of the macroeconomy.
We were quite surprised to learn many weeks later that our comment had been rejected by Applied Economics. The editor sent us two referee reports. Neither of the reports dealt directly with our primary comment, and both were defensive of the Barr, Mizrach, and Mundra paper. We noticed that in one of the reports, the referee identifies himself as one of the authors of the Barr, Mizrach, and Mundra paper, writing, “It is hard to reject a comment that agrees with your paper.” However, he managed to fight that urge and did reject our comment. It is not unheard of to send an author of an article a comment on their paper to referee, but it does seem odd to give them veto rights without the editor having read the paper and comment, which seems obvious in this case.
It is no embarrassment for a journal to publish a flawed paper. It happens on a regular basis. It is part of the academic process. For example, new econometric techniques have brought into question many early empirical papers. Hundreds of papers have been written on the Phillips Curve, and no doubt many are mistaken and now irrelevant. In the case of Barr, Mizrach, and Mundra, their paper is actually not wrong per se; they just came to the wrong conclusions based on their evidence. Even their secondary evidence could be salvageable. This experience provides a clear window into the messy world of academic publishing.
We expanded the comment into a paper with additional empirical evidence, and this paper was accepted for publication at the Quarterly Journal of Austrian Economics. There are other important developing lines of research on the Skyscraper Index, two of which I will report on next. One study looks at the Skyscraper Curse at the state level, the other examines the microeconomics of the Curse at the city level and helps explain the old real estate adage that what matters is “location, location, location.”
If I go there will be troubleAnd if I stay there will be double.So you gotta let me knowShould I stay or should I go? — The Clash, Should I Stay or Should I Go
The decision of where to locate your residence is difficult to make. Most of the factors that play a role in your decision-making are basically economic factors. So might this kind of decision-making process be somehow involved in the skyscraper curse? Economist Lucas Engelhardt thought so and wrote an insightful paper about it.
I have reiterated throughout this book that record-breaking skyscrapers and the skyscraper curse are merely symptomatic of what is going on throughout the economy when it is influenced by artificially low interest rates for a long period of time. We have already seen that it causes such things as local-record-breaking building heights in places such as Auburn, Alabama, advanced construction technologies, and advanced architectural innovations.
Many factors come into play with respect to the choice of the location of your residence. A big factor is that the cost of your house or apartment is one of your biggest expenses. Rent or mortgage payments are typically the largest single payments in your monthly budget. Once you have paid off your mortgage your standard of living can increase significantly.
Another big factor is that the decision is a long-term choice. If you plan to buy a house or condominium, then there are transaction costs such as moving expenses, realtor commissions, and attorney fees. You can reduce some of these expenses by placing a greater work burden and risk burden on yourself, but you cannot make them go away. Such costs occur every time you move.
These cost considerations also impact decision-making on the choice of apartments. If you sign a lease, then you are obligated to pay rent over the length of the lease. You also have moving costs, whether you pay a moving company or do the moving yourself. The upshot is that people typically spend time and effort acquiring information to make such decisions and typically do not make thoughtless and abrupt choices. So when you ask yourself, “Should I stay or should I go?” remember that there is a significant cost of moving.
Some of the factors that people consider when contemplating moving are housing prices and the amount of the monthly payment; the amount of property, income, and sales taxes; local amenities; the quality of local schools and shopping opportunities; crime rates; and commute time. The location of churches will also affect some people’s choices. There are trade-offs among all these factors. For example, people with young children will tend to put up with higher taxes if the local schools are good and crime rates are low. Another example is that some people would be willing to put up with long commute times if housing prices and taxes are low, local amenities and schools are good, and crime is low.
Lucas EngelhardtLucas Engelhardt, “Why Skyscrapers? A Spatial Economic Approach.” Unpublished manuscript, 2015. made a contribution to our understanding of the Skyscraper Index by providing a fuller theoretical explanation of why we should expect an uneven increase in land prices, rather than a general, even increase in land prices. By using location theory, Engelhardt shows theoretically why we should focus on very high skyscrapers rather than just tall buildings in general. In other words, he does not reject the notion that lower interest rates increase land prices and the height of buildings, but he provides theoretical support for the idea that land prices will increase relatively more in central business districts.
Of the three Cantillon effects, his focus is on the first effect, where artificially low interest rates change land prices, which leads to taller buildings. In my 2005 paperMark Thornton, “Skyscrapers and Business Cycles,” Quarterly Journal of Austrian Economics 8, no. 1 (2005): 51–74. the justification for taller buildings in this first effect was not really based on economic theory, but on real estate economics. However, I did provide some theoretical support for the uneven increase in land prices in the second Cantillon effect, where low interest rates caused an increase in company size, which in turn caused an increased demand for office space in central business districts.
Engelhardt uses William Alonso’sWilliam Alonzo, Location and Land Use: Toward a General Theory of Land Rent (Cambridge, MA: Harvard University Press, 1964). bid-rent model with a purely residential city where all employment opportunities are in the central business district. While not realistic, these assumptions are reasonable. In the model, each household budgets part of its income to pay rent and commuting expenses, and part of its time to cover the commute. The further you get from the central business district, the higher the commuting costs, which diminishes the amount you are willing to pay for rent. As you get closer to the central business district, your commuting time and expense decreases and your willingness to pay higher rent increases.
This trade-off is pretty familiar to many people: do you live near your job and pay higher rent, or do you live in the suburbs and endure substantial commuting cost and time? It is a trade-off between housing costs and commuting costs.
If commuting costs are very high, rents will be very high near the central business district (i.e., a steep trade-off), but if transportation costs are very low (e.g., free, ubiquitous high-speed trains), then rents will be similar near the center to what they are on the periphery (i.e., a shallow trade-off). But what determines the steepness of the trade-off? The quality of transportation services is obviously important, but also very costly to manipulate. For example, Dana RubinsteinDana Rubinstein, “Where the Transit-Build Costs Are Unbelievable,” Politico, March 31, 2015. reports that government transportation projects are notorious for being long delayed and over budget, with some projects exceeding $2 billion per mile. Engelhardt chose to focus on wage rates and interest rates, which pertain more generally across cities.
Here he employs Murray Rothbard’sMurray N. Rothbard, Man, Economy, and State (Auburn, AL: Mises Institute, 1962). concept of the discounted marginal revenue product of labor. Normally the difference between this and the mainstream concept of marginal revenue product is negligible, but Rothbard’s concept does introduce the interest rate and time preference into our theorizing about decision-making by adding time discounting to the mainstream concept.
When interest rates are very low you are less concerned with when you are paid because you lose very little interest. If interest rates are very high, then you want to receive your wages very quickly. Likewise, people who are paid daily are unconcerned about the interest rate, but people who are paid monthly or annually could be very concerned about changes in interest rates.
With respect to the skyscraper curse, when interest rates become artificially low, the discount rate on future sales of products decreases and thereby creates an increased demand for products; and this creates an increased demand for labor and higher wages rates. For example, if the interest rate on inventory paid by an automobile dealership falls from 10 percent to 1 percent, the dealer will want to carry a much larger inventory to better approach maximal profits. This increased inventory, reflected across the economy, will cause higher levels of production, employment, and wages.
What impact will these higher wages have on choice of location? Higher wages will have two distinct effects. First, higher wage rates will result in larger household budgets and a larger budget to pay for rent and commuting costs. Second, the higher wage rate makes a person’s commute time more expensive in terms of opportunity costs. For example, a lawyer who makes $500 per hour serving clients would have to consider a move from a 60-minute commute per day to a 120-minute commute per day as increasing their opportunity cost by $125,000 per year! Likewise, a lawyer who moved and reduced commute time from 60 minutes per day to living in his office and having no commute time would potentially increase their revenue by $125,000 per year.
Engelhardt finds that falling interest rates have an unambiguous impact on higher-wage individuals and the land closest to the central business district, although with lower-wage individuals and land near the periphery the effect is ambiguous. This means that artificially low interest rates induce people to want to move closer to the central business district. This in turn tends to increase land prices and causes taller buildings to be built. So during an artificial boom we would expect things like very tall condominium buildings to be built in central business districts.
If you relax the model and allow for office buildings the results are even stronger because businesses want to minimize travel costs for their employees, customers, and input suppliers. Therefore, they want to locate in the central business district, thereby driving land prices even higher. Engelhardt’s findings provide additional evidence for the Skyscraper Index and the skyscraper curse and his research highlights how artificial interest rates can influence our lives on a very personal level.
It has often been claimed that Austrian economist Ludwig von Mises predicted the Great Depression, but that is not quite true. He did predict in 1924 that a large Austrian bank would eventually fail, and he turned down a prestigious job at another large Austrian bank in 1929 because he did not want his name associated with its failure. Mises was clearly expecting a severe economic crisis, but as Murray RothbardMurray N. Rothbard, America’s Great Depression, 5th ed. (1963; Auburn, AL: Mises Institute, 2000). has shown, what made the Great Depression “great,” in that it was both severe and long lasting, were the policies implemented in response to the original crisis. Austrian business cycle theory (ABCT) is generally silent with respect to the timing and magnitude of the economic crisis.
The most important consideration here is that Mises published a thorough theoretical critique of existing monetary policy in the United States and elsewhere in 1928. That book is Monetary Stabilization and Cyclical Policy. Now we will look at opposing views regarding the business cycle of the late 1920s, most notably contrasting the views of Ludwig von Mises and his American counterpart, Irving Fisher.
The first “new era” of the twentieth century took place during the 1920s. People started to believe that this period of extended economic growth was actually one of self-sustaining growth and perpetually increasing prosperity. World War I had ravaged the developed world, central banks had been established across the globe, and the United States had become a leading economic and military power. The Progressive Era had reinvented America largely through constitutional change. Women now had the right to vote, there was a new federal income tax, and alcohol was prohibited across the nation. America also had joined the rest of the developed world by establishing a central bank with the passage of the Federal Reserve Act in 1913. The world was at peace and with a series of federal tax cuts in place, the United States had a very prosperous, although unstable, economy during the 1920s.Robert B. Ekelund, Jr., and Mark Thornton, “Schumpeterian Analysis, Supply-Side Economics, and Macroeconomic Policy in the 1920s,” Review of Social Economy 44, no. 3 (December 1986): 221–37.
There was also a technological revolution as important as the world has ever experienced. This was the decade when the airplane and automobile went into mass production. In communication, it was the onset of mass availability of the telephone and radio. Motion pictures were invented, along with household appliances such as the dishwasher, electric toaster, and refrigerator. The use of petroleum products and electricity increased dramatically while the use of manual power decreased significantly. Assembly line production became ubiquitous and was seen as the key to industrial progress.
The period of economic boom and stock market bubble during the 1920s is often referred to as the “Roaring Twenties.” Few people seemed to think it was unusual that the world’s three tallest buildings were being built either on or close to Wall Street, in New York City. However, it was far from a utopian time given all the crime, corruption, and violence created by alcohol prohibition, and there were clearly imbalances and instability in the economy. None of this, however, could discourage or dissuade the optimists that this was indeed a “new era.”
Edward AnglyEdward Angly, Oh Yeah? (New York: Viking Press, 1931). compiled quotations from newspapers and public records to chronicle the “new era” thinking during the bubble and its aftermath. A prime example of this thinking came from Herbert Hoover in his speech accepting the Republican Party nomination for president, where he proclaimed on August 11, 1928:
Unemployment in the sense of distress is widely disappearing. … We in America today are nearer to the final triumph over poverty than ever before in the history of any land. The poor-house is vanishing from among us. We have not reached the goal, but given a chance to go forward with the policies of the last eight years, and we shall soon with the help of God be in sight of the day when poverty will be banished from this nation. There is no guarantee against poverty equal to a job for every man. That is the primary purpose of the economic policies we advocate.Ibid., p. 9.
Not surprisingly Hoover believed the prosperity of the 1920s owed itself to the economic policies of his Republican Party, but his future policies to save jobs would be responsible for turning the economic crisis into the Great Depression.
Industrialists also saw a new era. Magnus Alexander, the president of the National Industrial Conference Board, said in 1927: “There is no reason why there should be any more panics.” The president of the Pierce-Arrow Motor Car Company, Myron Forbes, claimed on New Year’s Day, 1928, that there “will be no interruption of our present prosperity,” while Irving Bush, the president of the Bush Terminal Company proclaimed in November that “we are at the beginning of a period that will go down in history as the golden age.”
Charles Schwab, the chairman of Bethlehem Steel, noted in March 1929 that “I do not feel there is any danger to the public in the present situation” and in an October speech to the American Iron and Steel Institute reassured members that “in my long association with the steel industry I have never known it to enjoy a greater stability or more promising outlook than it does today.” As is typical of new-era philosophy, in October 1931, he blamed the depression on psychological factors: “The overliquidated prices of many securities are a sign of too short perspective and too excitable temperament.”
The financial press was similarly intoxicated with the economic bubble, with the Wall Street Journal reporting on October 26, 1929, “Conditions do not seem to foreshadow anything more formidable than an arrest of stock activity and business prosperity like that in 1923. Suggestions that the wiping out of paper profits will reduce the country’s real purchasing power seem far-fetched.” Syndicated columnist Arthur Brisbane reported four days later that “those that foolishly talk about a national panic, will please remember that the income of this nation is one hundred billion dollars per year.” In November he reported that “business is good, money is cheap” and that “it ought to be a good year.”
Shortly thereafter he encouraged his readers by reporting that “all the really important millionaires are planning to continue prosperity” and that “if every man would learn to talk about the country’s progress and future as a young mother talks about her new baby, there would be no danger of hard times.” On New Year’s Day, 1930, he declared the economic crisis was over, noting: “Now that the ‘big wind’ that swept through Wall Street, blowing away paper profits, has died down, there are sad hearts, but no real losses.” And one week later he wrote, “It is safe to say that the peak of idleness has about been reached, with better conditions coming.” As the economy worsened and unemployment continued to mount, Brisbane’s assurances became increasingly bizarre and macabre. On January 2, 1931, he wrote: “Sometimes when things go wrong, it is a comfort to be reminded that nothing matters very much. If the earth fell toward the sun, it would melt like a flake of snow falling on a red-hot stove.”
Politicians were big promoters and defenders of new-era thinking. Secretary of the Treasury Andrew Mellon told the American people near the peak of the boom that there “is no cause for worry. The high tide of prosperity will continue.” After the stock market crashed and unemployment began to rise, he reassured Americans on New Year’s Day of 1930:
I see nothing, however, in the present situation that is either menacing or warrants pessimism. During the winter months there may be some slackness or unemployment, but hardly more than at this season each year. I have every confidence that there will be a revival of activity in the spring and that during the coming year the country will make steady progress.Ibid., p. 23.
Republican officials continued to report throughout 1930 that the economy was fine, that conditions were satisfactory, that the worst was already over, that things would improve in a couple of weeks, and that signs of recovery were everywhere. However, by the end of 1930 some panic and confusion had entered into Republican ranks. On October 15, 1930, Simeon Fess, the chairman of the Republican National Committee, complained:
Persons high in Republican circles are beginning to believe that there is some concerted effort on foot to utilize the stock market as a method of discrediting the administration. Every time an Administration official gives out an optimistic statement about business conditions, the market immediately drops.Ibid., p. 27.
This statement is a sign of both alarm and paranoia and, if true, indicates that the “market” had finally entered a phase of disbelief in the pronouncements from the White House because of a large number of past inaccuracies.
Irving Fisher was the most prominent American economist of the period and is still considered by mainstream economists to be one of the greatest economists of all time. He was an enthusiastic supporter of Herbert Hoover and believed that the great economic prosperity of the 1920s was attributable in part to alcohol prohibition, which he championed, but more importantly he felt the prosperity was based on his theory concerning the “scientific” stabilization of the dollar that had been undertaken by the Federal Reserve. Naturally, with both alcohol prohibition and dollar stabilization firmly in place, Fisher was completely blindsided by the Great Depression. On the eve of the great stock market crash of September 5, 1929, Fisher reassured investors that he foresaw no problem in the stock market:
There may be a recession in stock prices, but not anything in the nature of a crash. Dividend returns on stocks are moving higher. This is not due to receding prices for stocks, and will not be hastened by any anticipated crash, the possibility of which I fail to see. A few years ago people were as much afraid of common stocks as they were of a red-hot poker. In the popular mind there was a tremendous risk in common stocks. Why? Mainly because the average investor could afford to invest in only one common stock. Today he obtains wide and well managed diversification of stock holdings by purchasing shares in good investment trusts.Ibid., 37.
Unfortunately, while Fisher continued to preach that stocks had reached a “permanent high plateau” throughout October 1929, stocks lost one-third of their value. Diversification via investment trusts, which were like the mutual funds of today, might have encouraged people to invest in stocks, but it did little to protect their wealth. The market value of investment trusts fell 95 percent over the two years following his prediction, and the Dow Jones stock index lost nearly 90 percent of its peak value.
Well after the fact, Irving Fisher identified in his 1932 book Booms and Depressions: Some First Principles most precisely and perceptively what he meant by a new era. In trying to identify the cause of the stock market crash and depression he found most explanations lacking. What he did find was that new eras occurred when technology allowed for higher productivity, lower costs, more profits, and higher stock prices:
In such a period, the commodity market and the stock market are apt to diverge; commodity prices falling by reason of the lowered cost, and stock prices rising by reason of the increased profits. In a word, this was an exceptional period — really a “New Era.”Irving Fisher, Booms and Depressions: Some First Principles (New York: Adelphi Company, 1932), p. 75.
The key development of the 1920s that clouded Fisher’s perception was that monetary inflation did not show up in price inflation as measured by price indexes. As FisherIbid., p. 74. noted: “One warning, however, failed to put in an appearance — the commodity price level did not rise.” He suggested that price inflation would have normally kept economic excesses in check, but that price indexes have “theoretical imperfections”:
During and after the World War, it (wholesale commodity price level) responded very exactly to both inflation and deflation. If it did not do so during the inflationary period from 1923–29, this was partly because trade had grown with the inflation, and partly because technological improvements had reduced the cost, so that many producers were able to get higher profits without charging higher prices.Ibid., p. 75.
Fisher had stumbled to a near-correct understanding of the problem of new-era thinking. Technology can drive down costs and increase profits, creating periods of economic euphoria, where economic signals would otherwise inject greater caution and clearer thinking. In other words, the Fed had kept interest rates artificially low, stimulating investments in technology beyond normal levels and thereby creating deflationary pressures in commodity prices.
However, he never lost his faith in scientific management of the economy or his devotion to the idea of a stable dollar, despite the implication that his stable-dollar policy had caused the Great Depression. Fisher’s detailed analysis and painstaking investigations of the crash also did little to improve his economic forecasting:
As this book goes to press (September 1932) recovery seems to be in sight. In the course of about two months, stocks have nearly doubled in price and commodities have risen 5½. European stock prices were the first to rise, and European buyers were among the first to make themselves felt in the American market.Ibid., p. 157.
He attributed this “success” to reflationary measures by the Fed that were of deliberate “human effort more than a mere pendulum reaction.”Ibid., p. 158. Unfortunately, not only was his prediction wrong, the world was only at the end of the beginning of the Great Depression and the “human effort” that he thought was the tonic of recovery was actually the toxin of lingering depression. He scoffed at the “mere pendulum reaction” of the market economy that can correct for the excesses in the economy by liquidating capital and credit, a concept that he clearly opposed. However, James GrantGrant, James. 1996. The Trouble with Prosperity: The Loss of Fear, the Rise of Speculation, and the Risk to American Savings (New York: Random House). and Tom WoodsThomas E. Woods, “Warren Harding and the Forgotten Depression of 1920,” Intercollegiate Review (Fall 2009): 22–29. have shown that this type of “pendulum reaction” worked extremely well during the short depression of 1920–21.
Was the Great Depression predictable? Was it preventable? The failure of the market economy to “right itself” in the wake of the Great Crash is the most pivotal development in modern economic history, and its impact has continued to shape mass ideology and to determine public institutions and policy. Unfortunately, few saw the development of the stock market bubble, understood its cause, or predicted the bust and the resulting depression.
In Austria, economist Ludwig von Mises apparently saw the problem developing in its early stages because of his theoretical insight concerning institutional and ideological changes. The world economy was controlled by central banks instead of the classical gold standard, and artificially reduced interest rates were widely considered to be a good thing. Mises forecast to colleagues the crash of the large Austrian bank Credit Anstalt as early as 1924. In a eulogy for his teacher Eugen von Böhm-Bawerk, Mises wrote in August 1924:
And no citizen of this country [i.e., Austria] shall forget the minister of finance, the last Austrian minister of finance [i.e., Böhm-Bawerk], who, in spite of all obstacles, earnestly aimed at balancing the public budget and preventing the upcoming financial catastrophe. (emphasis added)Ludwig von Mises, “The Economist Eugen v. Böhm-Bawerk, on the Occasion of the Tenth Anniversary of His Death,” translated Karl Friedrich Israel, Quarterly Journal of Austrian Economics 19, no. 2 (Summer 2016): 170. Originally published in Neue Freie Presse, Vienna, August 27, 1924.
As mentioned at the beginning of this chapter, Mises published a book-length critique of Irving Fisher’s ideas on monetary policy in 1928, titled Monetary Stabilization and Cyclical Policy. There he targeted Fisher’s “stable dollar” policy and its reliance on the price index as a key vulnerability that would bring about the economic crisis, concluding: “Because of the imperfection of the index number, these calculations would necessarily lead in time to errors of very considerable proportions.”Ludwig von Mises, “Monetary Stabilization and Cyclical Policy [Geldwertstabilisierung und Konjunkturpolitik],” in The Causes of the Economic Crisis: And Other Essays before and after the Great Depression, edited by Percy L. Greaves (1928; Auburn, AL: Mises Institute, 2006), p. 82.
Mises found that Fisher’s attempt to stabilize purchasing power was riddled with inherent technical difficulties and was incapable of achieving its goals: “In regard to the role of money as a standard of deferred payments, the verdict must be that, for long-term contracts, Fisher’s scheme is inadequate. For short-term commitments, it is both inadequate and superfluous.”Ibid., p. 84. He then demonstrated how Fisher’s type of monetary reforms cause booms and that these booms inevitably result in crisis and stagnation. He attributes the popularity of Fisher’s scheme to political influence and bad ideology:
The fact that each crisis, with its unpleasant consequences, is followed once more by a new “boom,” which must eventually expend itself as another crisis, is due only to the circumstances that the ideology which dominates all influential groups — political economists, politicians, statesmen, the press and the business world — not only sanctions, but also demands, the expansion of circulation credit.Ibid., p. 128.
Mises had addressed the same problems in a 1923 work, but named Fisher and his scheme in 1928. In addition to demonstrating the inevitability of the crisis, he clearly identified its cause, where most others could not:
It is clear that the crisis must come sooner or later. It is also clear that the crisis must always be caused, primarily and directly, by the change in the conduct of the banks. If we speak of error on the part of the banks, however, we must point to the wrong they do in encouraging the upswing. The fault lies, not with the policy of raising the interest rate, but only with the fact that it was raised too late.Ibid., p. 131.
He showed that the central bank’s attempt to keep interest rates low and to maintain the boom only makes the crisis worse. Despite the tremendous odds against the adoption of Mises’s own solution — that is, the traditional gold standard — he ended his analysis with a prescription for preventing future cycles:
The only way to do away with, or even to alleviate, the periodic return of the trade cycle — with its denouement, the crisis — is to reject the fallacy that prosperity can be produced by using banking procedures to make credit cheap.Ibid., p. 153.
Mark SkousenMark Skousen, Economics on Trial: Lies, Myths, and Realities (Homewood, IL: Business One Irvin, 1991). notes that in addition to Ludwig von Mises, Mises’s student F. A. Hayek is said to have predicted the collapse of the American boom in early 1929 (but probably not in written form). Felix Somary, who like Mises was a student at the University of Vienna, issued several dire warnings in the late 1920s; and in America economist Benjamin Anderson also warned that the Federal Reserve’s policies would cause a crisis, but like Somary, they were largely ignored. Mises and followers of his business cycle theory clearly had the upper hand over Fisher and the proponents of his stable-dollar policy.
Members of the Austrian school of economics were uprooted by WWII, with Mises in New York and Hayek in London and others scattered in academic posts at other prestigious universities. Despite the Austrians winning the prediction game against Fisher, Keynesian economics would soon rise to control economic thought as the Austrian school went into a general decline. Politically this was tied to the rise of fascism, Nazism, and FDR’s New Deal.
Fortunately, in the wake of WWII, the world returned to a Bretton Woods–style gold standard, and free market economies were established in Germany and Japan. The world quickly recovered from the war and the fascist-style economics that dominated prior to WWII. It would be a quarter century before the next economic depression hit the United States.
During the 1960s, when Keynesian economics came to completely dominate the economics profession, there was a large influx of the so-called new economists into government service. The disastrous results included the “Keynesianization” of the economy and what is best described as an economic depression that lasted throughout the 1970s and into the early 1980s. The long economic expansion of the 1960s came to a screeching halt just as 1 and 2 World Trade Center started to impact the Manhattan skyline.
Like the 1920s and 1990s, the decade of the 1960s was a period of remarkable prosperity in the United States as measured by statistics such as GNP and the unemployment rate. In contrast, the 1950s included several periods of stagnation and mild recessions. During the 1960s the economy grew at a brisk pace, and employment and wages grew as well. America was able to fight the Cold War, the Vietnam War, the War on Poverty, and win the space race, simultaneously. The only noticeable negative effect was a mild uptick in price inflation toward the end of the decade.
According to academic economist Arthur OkunArthur Okun, The Political Economy of Prosperity (Washington, DC: Brookings Institution, 1970), p. 57. the economic expansion was the result of two primary factors. The first was scientific management of the economy by the “new economists” who were brought to Washington to help fine-tune the economy with fiscal and monetary policy — that is, Keynesian economics. The second was the new technology that was introduced in the economy — particularly computer technology, consumer electronics, and technological advances related to space exploration.
Okun was the chairman of President Nixon’s Council of Economic Advisors from 1968 to 1969. Right before the crash he described the economic expansion as “unparalleled, unprecedented, and uninterrupted.” Okun believed that the economy was on a new “dramatic departure” from the past. According to Okun:
The persistence of prosperity has been the outstanding fact of American economic history of the 1960s. The absence of recession for nearly nine years marks a discrete and dramatic departure from the traditional performance of the American economy.Ibid., p. 31.
After declaring the business cycle dead, he went on to demonstrate that research on the business cycle was now a thing of the past and that a “new” approach to the economy had replaced it. In fact, he even took the precarious step of ridiculing those who stubbornly stuck to the old economics, where business cycles were viewed as an inevitable feature of the market economy. In fact, he charged this old school with viewing recessions in a positive light for correcting past excesses, just as Dr. Pangloss, a character in Voltaire’s play Candide, preaches optimism: everything, including negative things, is for the best, and we have the best of all possible worlds. Here I believe he is referring to Austrian economists, such as Ludwig von Mises and F. A. Hayek. Okun’s “latter-day Machiavellis” probably refers to political-business-cycle theorists who at this time were political scientists:
When recessions were a regular feature of the economic environment, they were often viewed as inevitable. Indeed, the Doctor Panglosses saw them as contributors to the health of our best of all possible economies, correcting for the excesses of the boom, purging the poisons out of our productive and financial systems, and restoring vigor for new advances. And the latter-day Machiavellis saw potentially great political significance in the timing of turning points. They spun out fantasies, suggesting or suspecting — depending upon whether their party was in or out of office — that the business cycle would be controlled so that the inevitable recession would come between elections and would be replaced by a vigorous economic recovery during the campaign period.Ibid., p. 32.
Okun confidently declared that the death of the business cycle was “proof par excellence” that economic controversies can be solved. How was the business cycle killed? Okun found that the slayer was not new theories or policy tools, but simply a more confident and scientifically rigorous implementation of existing tools, which resulted in efficient scientific management of the economy — that is, Keynesian economics:
More vigorous and more consistent application of the tools of economic policy contributed to the obsolescence of the business cycle pattern and the refutation of the stagnation myths. The reformed strategy of economic policy did not rest on any new theory.Ibid., p. 37.
For Okun, the New Deal had employed fiscal stimulus, which would later be espoused by Keynesian theory.Ibid., p. 43. He believed the old canard that WWII got us out of the Great Depression. As far as he was concerned those two episodes provided evidence of the success of countercyclical fiscal policy. He also viewed the old “fiscal religion” of limiting the size of government and keeping its budget in balance as nothing more than myth and superstition. Overthrowing those fallacies of the past and embracing scientific management of the economy had allowed economists to fully apprehend and subdue the business cycle: “The activist strategy was the key that unlocked the door to sustained expansion in the 1960s.”Ibid. All remaining errors could be dealt with by fine-tuning of the activist strategy.
It was unfortunate for Okun that the publication of his book, The Political Economy of Prosperity, occurred just one month before the next economic recession began. Civilian unemployment increased from well below 4 percent to just over 6 percent by the end of 1970. The rate then retreated to 5 percent in 1973 only to skyrocket to 9 percent in mid-1975 — the highest rate since the Great Depression. The unemployment rate remained above the “natural rate” of 5 percent for the next two decades, including ten months of double-digit unemployment during 1982–83.
The experiment of the new economists also resulted in higher price inflation, as would be expected from the “stimulating” fiscal and monetary policy of the 1960s. From the beginning of 1946 to the beginning of 1965 — twenty years — the Consumer Price Index increased by 71.4 percent, but it then increased another 20 percent by the end of the 1960s. From 1965 — when the experiment began in earnest — to the end of 1980 the CPI increased by 176.6 percent. The grand experiment greatly increased the price inflation experienced by consumers.
More importantly, revolutionary changes occurred in money and banking. The US Treasury stopped issuing silver coins in 1964, and Gresham’s law ensured that Americans were soon using nothing but “clad” coins that only looked like the old silver coins. Silver-certificate notes were recalled in 1968 in exchange for Federal Reserve Notes. Then, in August 1971, Nixon initiated a “new economic policy” that closed the international gold window (where foreign central banks could still redeem dollars for gold), the last vestige of the pre-1913 classical gold standard.
The United States had printed too much money during the 1960s and had caused a “run” on the dollar by foreign central banks, which sought to cash in their dollar holdings for gold. Despite US promises to the contrary, Nixon also instituted comprehensive wage and price controls in an attempt to block the rising price inflation before his reelection campaign. The Bretton Woods system, where currencies had fixed values in terms of gold, inevitably collapsed. Thus the last links between gold and money were broken and a completely fiat monetary system was established.
The bubble of the 1960s and the subsequent collapse have been well chronicled by John Brooks in his book The Go-Go Years. The “go-go ’60s” refers to the market for technology stocks during the 1960s, when the “Nifty Fifty” emerged as a list of “one decision” stocks that could be bought and held forever. This list of stocks included Coca-Cola and IBM as well as troubled companies of the future, such as Kodak and Polaroid. Like the investment trusts of the 1920s, mutual funds were touted as the fastest path to riches for the common man. As the bubble expanded, investment gurus such as Gerald Tsai used aggressive investment techniques to generate huge increases in the value of their mutual fund shares, while others made millions building the conglomerate corporations that spanned many industries and nations.
John BrooksJohn Brooks, The Go-Go Years: The Drama and Crashing Finale of Wall Street’s Bullish 60s (New York: Allworth Press, 1973), pp. 137–39. well captured the euphoria that emanated from this new-era stock market: “As mutual-fund asset values went up, new money poured in. Tsai and others like him seemed to have invented a money-making machine for anyone with a few hundred or several thousands of dollars to invest.” He even labeled Tsai “the first big-name star of the new era.” Unfortunately, Brooks was unable to properly diagnose the cause of the mania, attributing it largely to greed and irrationality:
Where were the counsels of restraint, not to say common sense, in both Washington and on Wall Street? The answer seems to lie in the conclusion that in America, with its deeply imprinted business ethic, no inherent stabilizer, moral or practical, is sufficiently strong in and of itself to support the turning away of new business when competitors are taking it on. As a people, we would rather face chaos making potsfull of short-term money than maintain long-term order and sanity by profiting less.Ibid., p. 187.
Brooks noted that “man’s apparent capacity to learn from experience is an illusion.” Man is able to benefit from experience, but our collective ability to learn and pass knowledge on to future generations depends on our ability to formulate correct theories regarding our experiences. Like many others, Brooks seems oblivious to the usefulness of economic theory in this regard, although his analysis regarding experience and lack of a stabilizer does reflect favorably on Austrian business cycle theory.
However, Brooks is correct and quite methodical in showing the similarities between the 1920s and the 1960s. In each case there was a new era and a new way of economic thinking. Both episodes had their investment stars that fell into disgrace. In both cases there were charges of corruption and malfeasance that led, after the fact, to attempts at reform via legislation. At the heart of both eras — the vehicle of mania and deception — was technology. By the history of Wall Street, Brooks was able to show that the collapse in the stock market was actually much worse than the Dow Jones stock index indicated. Many of the best-performing stocks of the decade turned into the worst-performing stocks of the next decade, but were not in the Dow index. This spelled trouble for many investors for years to come.
An even better indicator of trouble in the stock market can be found in the fact that in May 1970, a portfolio consisting of one share of every stock listed on “the Big Board” was worth just about half of what it would have been worth at the start of 1969. The highfliers that had led the markets of 1967 and 1968 — conglomerates, computer leasers, far-out electronics companies, franchisers — were down precipitously from their peaks. Nor were they down 25 percent, like the Dow, but 80, 90, or 95 percent. This was vintage 1929 stuff, another economic depression, with all the economic pain and emotional hardship that mired both stock markets and the economy for years to come.Ibid., p. 4.
The stock market as measured by the Dow did decrease 25 percent between 1969 and 1971 and then, after the publication of Brooks’s book, lost another 20 percent by mid-1975. However, the inflation-adjusted losses in the stock market were larger and longer lasting than an ordinary price chart of the Dow might suggest. The inflation-adjusted or “real” purchasing-power measure of the Dow indicates that it lost nearly 80 percent of its peak value during this time period. When Brooks drew out the similarities between 1929 and 1969, he stopped short of declaring a second Great Depression. However, while the economic pain of the 1970s and early 1980s may not have matched the Great Depression of the 1930s, it could easily qualify as an economic depression.
The decade began with recession and the abandoning of the gold monetary system and saw the emergence of “stagflation” — that is, stagnation and inflation. It ended with the highest monthly misery index in 1980. The index is calculated by adding the inflation rate to the unemployment rate. The 1970s is not generally recognized as a depression by economists. However, it certainly was part of a twelve-year period of economic pain and uncertainty compounded by price controls, the gasoline shortages, Watergate, and defeat in the Vietnam War. It should also be noted that mainstream economists have changed the meaning or application of terms such as depression, panic, and crisis, substituting milder-sounding terms such as recession and correction.
Statistical evidence clearly demonstrates that the 1970s was a turning point in the wrong direction for the American economy. The Bretton Woods gold standard was abandoned, prices increased, and the dollar rapidly depreciated. Unemployment and underemployment increased, and they set post-WWII highs in the early 1980s. The federal government abandoned a longstanding tradition of balanced budgets for the current regime of ever-increasing deficits and a skyrocketing national debt. The personal saving rate of Americans — which had been on an increasing trend until 1971 — flattened out and began its current declining trend toward a zero savings rate.
It was the 1970s when the trade balance first destabilized, and then began the trend of escalating trade deficits. Naturally when the people are saving less and the government is borrowing more, the new loans have to come from foreigners. Going back to the 1930s, net exports of goods and services hugged the zero line. Then in the 1970s it broke below the zero line and continued to head lower. For the fifteen years leading up to 2010, the trade deficit averaged over $500 billion. The stability of the past had been replaced with the instability and erosion that fiat paper money inevitably brings.
Another crucial factor is the impact of the monetary regime on income distribution, one of the most glaring issues of our times. Money is one important factor that is largely ignored by those both on the political left and the political right. It is also largely ignored by mainstream economists, such as Thomas Piketty (2014).Thomas Piketty, Capital in the Twenty-First Century (Cambridge, MA: Harvard University Press, 2014). However, the choice of monetary system and monetary policy does have predictable and historically validated effects on economic inequality.
A monetary system that is dominated by a central bank, such as the Federal Reserve, and uses fiat money, as in our current monetary system, can expect to benefit certain people, such as bankers, financiers, and people with debt. Likewise, because such a system is inflationary, it tends to hurt wage workers and savers. Such a system can be expected to hurt the lower- and middle-income classes and enrich those in the financial industry and the upper-income class.
A gold standard has historically had a tendency for prices to be stable or slightly deflationary. This means that wage rates, cash balances, savings, and bonds tend to gain purchasing power over time. This type of monetary system rewards the hard-working and frugal classes, which leads to an expansion of the middle-income class and the economy.
This graph from the Pew Research Center provides enticing evidence of the differential impact of gold versus fiat paper money.
The graph shows that economic inequality declined in the United States from 1917 to the early 1970s, when Nixon took the United States off of the Bretton Woods gold standard. The darker shaded areas of the graph represent the 99 percent, while the light area at the top represents the percentage of total income of the upper 1 percent. Economic inequality increased during the inflationary 1920s, but the lower-income classes rapidly improved versus the 1 percent when the gold standard was restored after WWII. The graph shows both marginal improvement and stability in economic inequality from the late 1940s to the early 1970s. Since going off the gold standard in 1971 the trend has been for much greater economic inequality.
All of these problems were not due to the laziness of the American people. Females moved into the workforce in record numbers, and the two-income family was established, mostly to try to maintain standards of living. Unfortunately, the 1960s and 1970s were two decades when government employment expanded the most, so that much of this increased labor effort produced little of value. Working for government can even be a net negative for the economy in the sense that government employees can do actual harm to the production of useful goods and services. The “new economists” in the service of the state are a good example of that.
The 1960s and 70s were precarious times for the Austrian school. Ludwig von Mises was very old, retired, and would die in 1973 at the age of ninety-two. Friedrich Hayek was also retired and ensconced at the University of Salzburg in Austria from 1969 to 1977. He called his move to Salzburg a mistake. He had not worked on business cycles and monetary policy for many decades and his research interests at this time were very different. Henry Hazlitt retired from Newsweek in 1966 at the age of seventy-two. Murray Rothbard was a young man and was marginalized and isolated, with little institutional support. There were precious few other Austrian economists in the entire world, and the next generation of Austrian economists had not left graduate school or had not even entered graduate school.
Mises at the age of eighty-nine continued to lecture during the critical 1968–70 period, and make public appearances. Some of his more important lectures included: “The Problems of Inflation” (April 3, 1968); “On Money” (April 3, 1969); “The Balance of Payments” (May 1, 1969); “A Seminar on Money” (November 8, 1969); “The Free Market Society” (February 21, 1970), where he discussed the problems arising from increasing the supply of money; and “Monetary Problems” (June 23, 1970), where he discussed why the return to the true gold standard was so important and essential for economic growth and stability and why the Bretton Woods system was so problematic. Sampling these lectures makes it obvious that Mises in his elder years was completely attuned to the monetary-policy problems and their potential consequences and was doing his best to alert others of the looming dangerous outcomes.
Henry Hazlitt was hardly retired either. After leaving Newsweek in the fall of 1966 he began writing for the Los Angeles Times, and between the fall of 1966 and June 1969 Hazlitt published 177 articles in the Times.Jeffrey A. Tucker, Henry Hazlitt: A Giant of Liberty (Auburn, AL: Mises Institute, 1994). Almost all of the articles discussed the dangers looming because of current monetary and fiscal policy. He clearly saw that the Bretton Woods gold standard was the core problem because it led to too much government spending and a loose monetary policy. For example, he wrote articles such as “Budget Out of Control” (February 12, 1967), “People Want Gold” (February 22, 1967), and “Currency Crisis Ahead” (March 29, 1967) in early 1967. In 1968 he wrote “What a Gold Reserve Is For” (February 3, 1968), “The Most Irresponsible Budget” (February 11, 1968), and “The Dollar Crisis: A Way Out” (March 17, 1968). Hazlitt wrote in 1969 on topics like “The Coming Monetary Collapse” (March 23, 1969), “Pretending That Paper Is Gold” (May 4, 1969), and “Good-Bye to the ‘New Economics’” (June 8, 1969). Hazlitt clearly saw the critical fault in the Bretton Woods System: that the US government would overspend — for example, spending on the Vietnam War, the space mission to the moon, and the War on Poverty — and pay for it by printing dollars. He clearly saw early on that the Bretton Woods–style gold standard would collapse, which it did in 1971.
Murray Rothbard was also keenly aware of what was happening to the US economy in the late 1960s. He published a small pamphlet on the subject of business cycles in 1969 — Economic Depressions: Their Cause and Cure. This was just prior to the end of the longest expansion in US history and the beginning of thirteen years of stagflation and depression. It is very similar to Mises’s book The Causes of the Economic Crisis published the year before the stock market crashed in 1929. Rothbard would continue writing about the looming crisis and the role of the Austrian business cycle theory:
In the sphere of economics the Nixon Administration had been highly touted among conservatives. It was supposed to herald a return to the free-market and a check upon galloping inflation through monetary restriction. Again, nothing has happened. The much publicized monetary tightening has been half-hearted at best, and provides no real test of the effectiveness of monetary policy. For the Administration has been doing precisely what its spokesmen had been deriding the Democrats for doing: trying to “fine-tune” the economy, trying to cut back ever so gently on inflation so as not to precipitate any recession. But it can’t be done. If restrictionist measures were ever sharp enough to check the inflationary boom, they would also be strong enough to generate a temporary recession.Murray N. Rothbard, “Nixon’s Decisions,” Libertarian Forum 1, no. 8 (July 15, 1969): 1.
Rothbard continued his assault on Nixon’s economic policies:
The phenomenon of inflationary recession cannot be understood by Establishment economists, whether of the Keynesian or the Milton Friedman variety. Neither of these prominent groups has any tools to understand what is going on. Both Keynesians and Friedmanites see business cycles in a very simple-minded way; business fluctuations are basically considered inexplicable, causeless, due to arcane changes within the economy, although Friedman believes that these cycles can be aggravated by unwise monetary policies of government.Ibid., p. 4.
In contrast, Rothbard was keenly aware of this political dilemma, the “inflationary recession,” because he attended some lectures by his then thesis advisor Dr. Arthur F. BurnsDoug French, “Arthur Burns: The Ph.D. Standard Begins and the End of Independence,” in The Fed at One Hundred: A Critical Review on the Federal Reserve System, edited by David Howden and Joseph T. Salerno (Heidelberg, New York, London: Springer, 2014), pp. 91–102. at Columbia University in 1958. Rothbard recalled the incident with his professor and later chairman of the Federal Reserve:
I remember vividly a prophetic incident during the 1958 recession, when the phenomenon of inflation-during-recession hit the country for the first time. I attended a series of lectures by Dr. Arthur F. Burns, former head of the Council of Economic Advisers, now head of the Federal Reserve Board, and someone curiously beloved by many free-market adherents. I asked him what policies he would advocate if the inflationary recession continued. He assured me that it wouldn’t, that prices were soon leveling off, and the recession would soon be approaching an end; I conceded this, but pressed him to say what he would do in a future recession of this kind. “Then,” he said, “we would all have to resign.” It is high time that we all took Burns and his colleagues up on that promise.Murray N. Rothbard, “The Nixon Mess,” Libertarian Forum 2, no. 12 (June 15, 1970): 1–3.
Rothbard is directly confronting the “new economists” and their beloved Phillips Curve analysis with the phenomenon we now call stagflation, which Rothbard called an “inflationary recession.”
Rothbard also attacked the Nixon administration’s labor guidelines and income policy. He correctly predicted that such policies would likely lead to wage and price controls, which they did the following year:
While we can firmly predict accelerating inflation, and dislocations stemming from direct controls, we cannot so readily predict whether the Nixonite expansionism will lead to a prompt business recovery. That is problematic; surely, in any case we cannot expect any sort of rampant boom in the stock market, which will inevitably be held back by interest rates which, despite the Administration propaganda, must remain high so long as inflation continues.Murray N. Rothbard, “Nixonite Socialism,” Libertarian Forum 3, no. 1 (January 1971): 1–2.
Rothbard went on to show that Keynesian and Friedmanite economists cannot understand this phenomenon and have no way to address such problems. In contrast, he showed how Austrian economists can understand this phenomenon through price theory and capital theory and that they do have policy recommendations on how best to address the problems of stagflation. Interest rates must be raised in order to flush out malinvestments and price inflation from the economy.
F. A. Hayek was awarded the Nobel Prize in economics in 1974 for his work building on Mises’s writings on business cycle theory. Hayek had been working in isolation in Austria and concentrating on his research in entirely different directions for some years. However, when the crisis hit in the early 1970s he rushed back into action. Hayek’sF. A. Hayek, “The Outlook for the 1970s: Open or Repressed Inflation?” in Tiger by the Tail: The Keynesian Legacy of Inflation, edited by Sudha R. Shenoy (Washington, DC: Cato Institute, 1972). first publication on this issue was put together by Sudha R. Shenoy, the daughter of the great Indian economist B. R. Shenoy. She seamlessly strung together materials from Hayek’s early writings on money and business cycles into a coherent monograph. To this 1972 book, Hayek contributed the essay “The Outlook for the 1970s: Open or Repressed Inflation?” He also published three monographs — Choice in Currency: A Way to Stop Inflation (1976), Denationalization of Money: The Argument Refined (1977), and Unemployment and Monetary Policy: Government as Generator of the “Business Cycle” (1979) — that sought to address the problem of the monetary crisis and economic depression.
The Austrians of the time were few but they turned out to be very vocal and correct about the threat of economic crisis. In fact their emphasis on raising interest rates and stopping the money printing might have been very influential in the form of the interest rate policy adopted by Fed chairman Paul Volcker (1979–87). It did cause a severe contraction, but it did end the monetary and price inflation and set the stage for a robust recovery.
It should also be noted that Dr. Ron Paul, an advocate of Austrian economics, decided in 1971 to run for a seat in the House of Representatives because Nixon had taken the United States off the gold standard. He has helped build a worldwide movement for Austrian economics. Also, the Cato Institute was founded in 1974 by Ed Crane, Murray Rothbard, and Charles Koch. The Cato Institute in 1982 published the monographs by F. A. Hayek, as well as The Case for Gold: A Minority Report of the U.S. Gold Commission, by Ron Paul and Lewis Lehrman.Ron Paul and Lewis Lehrman, The Case for Gold: A Minority Report of the U.S. Gold Commission (Washington, DC: Cato Institute, 1982), which was based on the research of Murray Rothbard. Finally, the Ludwig von Mises Institute was founded in 1982 by Llewellyn H. Rockwell, Jr.; its premier mission is to educate people about the benefits of a true gold standard as described in the Gold Commission’s minority report. The monetarist-packed US Gold Commission won the battle to maintain fiat money, but Ron Paul, the Cato Institute, the Mises Institute, and the Austrian school have all grown enormously in influence since then.
Science is prediction. — Motto of the Econometrics Society
Those who have knowledge, don’t predict. Those who predict, don’t have knowledge. — Lao Tzu
Predicting economic behavior is inherently difficult. As Niels Bohr joked, “Prediction is very difficult, especially if it’s about the future.”
Originally published “Who Predicted the Bubble and Who Predicted the Bust?” Independent Review 4, no. 1 (Summer 2004): 5–30. Excerpted here and reprinted with permission.
Quotation at http://www.brainyquote.com/quotes/quotes/n/q130288.html
People’s economic actions are subject to choice and change, unlike the subject matter of the physical sciences, which has fixed properties. Therefore, the future must remain uncertain. Predicting the economy as a whole is fraught with additional dangers and complications, and all leading indicators of economy-wide change either do not have or eventually lose the capacity to predict the future accurately. As Paul Samuelson once quipped, “Wall Street indices predicted nine out of the last five recessions.”Paul A. Samuelson, “Science and Stocks,” Newsweek, September 19, 1966, p. 92. In light of these difficulties, economists have taken widely divergent positions on prediction.
Many modern mainstream economists, like their colleagues in the physical sciences, view prediction as the essence of science. If you cannot predict with a high degree of accuracy, then you are not being scientific. You must put your science to the empirical test and pass that test. The dominance of positivism in economic methodology encourages economists to worry less about the logical consistency of their models and to concentrate more on the development of models that exploit historical data in making predictions. Government and business economists then use the models to forecast variables such as gross domestic product, interest rates, unemployment, company sales, stock prices, housing starts, and demographic changes.
There is also substantial support for the position that we cannot predict and that economists have a terrible forecasting record. With respect to the technology bust in 2001, Mike Norman put this view of economists in perspective:
I’m an economist. Big deal, right? Until last year, economists got even less respect than Wall Street analysts; now, we’re just a notch above. Admittedly, this reputation is well-deserved, because it comes from our less-than-stellar ability to get economic forecasts right. With all of that data and plenty of powerful computing ability, you’d think we could produce better forecasts. Heck, even the local weatherman puts us to shame.Mike Norman, “Dismal Science May Get a Little Sunnier,” Special to the Street, April 21, 2003.
“The Street,” having witnessed countless forecasts go wrong, is naturally suspect. As Lindley Clark once noted in the Wall Street Journal, “Economists have a great deal of trouble predicting the future, and it’s unlikely that this unhappy situation ever will change.”Lindley H. Clark, Jr., “Housing May Be in for a Long Dry Spell,” Wall Street Journal, January 19, 1990. Indeed, some economists think that forecasts are akin to “magic” and that such magic is contradicted by the very essence of economic science. Deirdre McCloskey has expounded on this view of economic forecasts:
Economics is the science of the postmagical age. Far from being unscientific hoobla-hoo, economics is deeply antimagical. It keeps telling us that we cannot do it, that magic will not help. Only the superstitious think that profitable forecasts about human action are easily obtainable. That is why economics, contrary to common sneer, is not mere magic and hooblahoo. Economics says that forecasts, like many other desirable things, are scarce. It cannot be easy to know what great empire will fall or when the market will turn. “Doctor Friedman, what’s going to happen to interest rates next year?” Hoobla-hoo. Some economists allow themselves to be paid cash money to answer such questions, but they know they cannot. Their very science says so.Donald McCloskey, “The Art of Forecasting: From Ancient to Modern Times,” Cato Journal 12 (Spring–Summer 1992): 40.
Though agreeing in the main that forecasting has questionable value, Michael BordoMichael Bordo, “The Limits of Economic Forecasting,” Cato Journal 12 (Spring–Summer 1992): 47. claims that forecasting has some scientific and practical value and is not all just snake oil and magic. He notes that not all economists have been such dismal failures as forecasters: Richard Cantillon made correct predictions about John Law’s Mississippi Bubble system based on economic theory, and he made a fortune as a result.
Others, following the famous Chinese philosopher Lao Tzu, are skeptical about the prospects for prediction but do not altogether reject the possibility of accurate prediction. They merely restrict themselves to hypothetical and qualitative prediction. Foremost among this group are the Austrian-school economists, who reject the notion of fixed relations between human-controlled variables and even the idea that data can be used to “test” an economic theory. Austrian economist Ludwig von Mises rejected the general notion of forecasting and claimed that economics can provide only qualitative predictions about particular policies:
Economics can predict the effects to be expected from resorting to definite measures of economic policies. It can answer the question whether a definite policy is able to attain the ends aimed at and, if the answer is in the negative, what its real effects will be. But, of course, this prediction can be only “qualitative.” It cannot be “quantitative” as there are no constant relations between the factors and effects concerned. The practical value of economics is to be seen in this neatly circumscribed power of predicting the outcome of definite measures.Ludwig von Mises, The Ultimate Foundations of Economic Science: An Essay on Method (Princeton, NJ: D. Van Nostrand, 1962), p. 67.
The problem of predicting (with the goal of preventing) stock market bubbles and crashes is especially important, not just because busts result in huge financial loses for some investors, but because many of these extreme financial cycles can disrupt the financial system and lead to real economic contractions.Frederic S. Mishkin, and Eugene N. White, “Stock Market Bubbles: When Does Intervention Work?” Milken Institute Review: A Journal of Economic Policy 5 (2nd quart. 2003). Unfortunately, economists have yet to develop a generally accepted view of bubbles and have little to offer in predicting them.
Bubble Predictions If you can look into the seeds of time, and say which grain will grow and which will not, speak then unto me.— William Shakespeare, Macbeth
Responsible economists and economic analysts should have been warning the public about the prospects of a market crash and its implications for both the economy as a whole and their personal fortunes. However, few economists were issuing such warnings.— Dean Baker, “Dangerous Minds? The Track Record of Economic and Financial Analysts”
One person who did issue warnings regarding the stock market bubble and the problems a stock market crash might generate was Dean Baker of the Center for Economic and Policy Research. In the aftermath of the technology bust in 2001, he made the following observations:
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It should have been very simple for any competent analyst to recognize the bubble as the ratio of stock prices to corporate earnings hit levels that clearly were not sustainable in the late nineties. … The failure to recognize the bubble and warn of its consequences stems in part from a misunderstanding of the stock market and its role in the economy. …
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While there were some economic analysts who did warn of the market bubble, their views were almost completely excluded from the media. …
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Due to their failure to recognize the stock market bubble, official forecasters, like the Congressional Budget Office (CBO) and the Social Security Administration (SSA), made projections that were implausible on their face. …
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Most managers of large investment funds, including public and private pensions, and university and foundation endowments, failed to see the bubble and its inevitable collapse. … While the failure to recognize and warn of the stock bubble amounted to an enormous professional lapse, few economic or financial analysts seem to have paid much of [a] price for their mistake.Dean Baker, Dangerous Minds? The Track Record of Economic and Financial Analysts (Washington, DC: Center for Economic and Policy Research, 2002), p. 3.
I myself presented such warnings and analysis in public lectures, radio broadcasts, and newspaper articles and on the internet, but with little or no effect. In a public lecture in Houston on July 15, 1999, I addressed an audience about Alan Greenspan’s “luck” in increasing the money stock without price inflation, and I warned that the Fed’s actions inevitably would have negative economic consequences, especially for stocks and the dollar. I appeared on the Financial Sense News Hour on April 3, 2000, and April 4, 2001, and on a radio show called Credit Bubble.See http://www.financialsense.com/Experts/Thornton.htm On the Barstool Economist list on January 5, 2001, and January 7, 2001, I issued warnings that the dollar (then near its peak) would probably weaken over time. I also wrote several letters to newspapers, such as Investor's Business Daily, during this period, none of which was printed.
The Wall Street Journal’s semiannual survey of economic predictions indicates that forecasters have had difficulties in understanding the stock market bubble. The survey released on January 4, 1999, found forecasters to be concerned about the economy and forecasting low rates of economic growth, the majority expecting higher inflation and a 30 percent chance of entering a bear market in stocks. The survey released July 2, 1999, found those same economists raising their forecasts of the GDP growth rate by 50 percent for the remainder of 1999 in response to higher-than-predicted growth rates in early 1999. Even though they remained personally bullish on the stock market, they expressed greater concern about a bear market beginning in 1999. After the Y2K crisis passed, the survey released on January 3, 2000, found economists to be euphoric about the prospects for 2000. “There is no end in sight to the expansion,” said Allen Sinai, an economist at Primark Corporation. The group remained bullish on stocks, and 95 percent of the forecasters attached a probability of less than 30 percent to the onset of a recession. Only longtime bear Gary Shilling forecast a recession based on the stock market’s crashing. After a decline of more than 30 percent in the NASDAQ index, the survey released on July 3, 2000, found economists confident that the Federal Reserve (the Fed) would engineer a “soft landing”; the optimists believed in the Fed’s perfect soft landing, whereas the pessimists foresaw a soft landing but worried that the Fed would not do enough to fight inflation. However, the group finally was starting to express more concern about the future of the economy and the stock market. These forecasters’ record seems extremely weak. Even as reported by the Wall Street Journal, their record is poor: they seemed to have no clue about changes in the economy’s short-term outlook, instead simply projecting the historical trends forward.
The record of government economists mirrors that of Wall Street analysts. I compare forecasts from the Congressional Budget Office (CBO) and the White House with those from Wall Street in table 1. Under each group’s heading, its annual forecasts for the period 1992–2002 are compared with actual economic growth rates. From 1992 through 1996, the forecasts were accurate as the economy followed the trend line. From 1996 through 2000, forecasters from all three groups underestimated economic growth rates as the economy and the stock market went into the bubble phase. Then, from 2000 to 2002, they all overestimated economic growth rates, following the trend and failing to anticipate the meltdown in the stock market and the economy. The mean absolute error for all three groups was approximately one percentage point, so their average forecast for growth rates was off by approximately 20 percent.
Two of the most famous predictions concerning the stock market came from James K. Glassman and Kevin A. Hassett in their 1999 book Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock MarketNew York: Random House. and from Robert J. Shiller’s Irrational ExuberancePrinceton, N.J.: Princeton University Press. in 2000.
Some traditional investment advisors were quick to warn against Glassman and Hassett’s recommendations. In particular, Charles Murray of the American Institute for Economic Research noted that such books are often a harbinger of disaster:
At the time (October 25, 1999), we said that books such as Dow 36,000 seem mainly to make their appearance at or near market tops. In fact, investors had their choice among Dow titles in the past year: David Elias explained why the Dow will reach 40,000 in Dow 40,000; whereas Charles W. Kadlec and Ralph J. Acampora predicted (although wouldn’t guarantee) that the Dow will eclipse 100,000 in — you guessed it — Dow 100,000.Charles Murray, “Bubble Trouble,” Research Reports 67, no. 11 (June 12, 2000): 63.
Murray’s traditional approach led to the conclusion that the market was in a bubble and to a prediction that a crash or bear market was imminent. Readers could have protected themselves against the crash by acting on Murray’s advice:
Readers of these Reports know that for some time we have noted that the market’s valuation of common stocks has been markedly high in relation to most measures used in security analysis — cash flow, book value, earnings, etc. However, the historical record does not tell us what the “right” valuation is, only that the current valuations are exceptional. We have also observed that the current bull market is of unprecedented duration and magnitude and that at some point a genuine bear market or even crash can be expected. Again, at what point this valuation becomes unsustainable is far from clear.Ibid., p. 64.
Murray noted that the traditional valuation methods have shortcomings and that for larger purposes, such as the prevention of bubbles, valuation techniques do not tell us what causes bubbles in the first place.
Another good foil to Glassman and Hassett is economics and financial writer Christopher Mayer,Christopher Mayer, “The Meaning of Over-valued,” Mises Daily, March 30, 2000. who investigated and wrote about their book during its heyday. He concentrated on the meaning of the term overvalued — not so much on how to determine when something is overvalued numerically, but on the cause, meaning, and effect of overvalued stocks. Specifically, he criticized the notion of perfectly rational and efficient markets and showed how markets can, in a sense, lose their rationality. First, Mayer introduced the general mindset of the new paradigm that dominated the view of the market during the bubble, and he linked Glassman and Hassett to this mindset:
Are stocks overvalued? One answer is that it depends on whom you ask. Those who are buying and holding apparently think that they will be able to sell them at higher prices. Maybe they believe in a new paradigm where the old yardsticks of value are useless. James Glassman and Kevin Hassett recently wrote a book called Dow 36,000 in which they maintain that the stock market is currently undervalued.Ibid.
Next, he made his own prediction, linking Glassman and Hassett with the hapless Irving Fisher. More important, he explained specifically why a bubble existed, rather than arguing simply that the market was overvalued by some historical yardstick:
Looking back, future financial historians will likely relate the Glassman/Hassett thesis to Irving Fisher’s famous proclamation in 1929 that “stock prices have reached a permanent and high plateau.” James Grant likes to say that there are three common features of a bubble: one part fundamental (i.e., a technological revolution), one part financial (i.e., a surge in money and credit) and one part psychological (i.e., a suspension of belief in traditional valuation measures). All the ingredients would appear to exist in the current bull market.
As is often said, only time will tell. Unfortunately, no theory of cycles or bubbles can tell us precisely when it will all end. Maybe twenty years from now, we will be able to definitively state whether these prices were reasonable or whether the boom time of the 1990s ended in a bust. From where I sit, heeding the teachings of the Austrians, I’ll place my bet on the latter.Ibid.
One of the earliest prognostications regarding the boom and bust was certainly the one mentioned by analyst James Grant, the editor of Grant’s Interest Rate Observer. Grant closed his book The Trouble with Prosperity, written in May 1996 “at what may or may not prove to be the ultimate peak of the speculative frenzy,” with the following conclusions:
Predictably, the risks to saving are the greatest just when they appear to be the smallest. By suppressing crises, the modern financial welfare state has inadvertently promoted speculation. Never before has a boom ended except in crisis. In anticipation of just such an outcome, a skeptical Seattle investor, William A. Fleckenstein, founded a hedge fund in 1995 to buy cheap stocks and to sell dear ones. He named it The RTM Fund, the initials signifying “reversion to the mean.” They may be the financial watchwords for the millennium.James Grant, The Trouble with Prosperity: The Loss of Fear, the Rise of Speculation, and the Risk to American Savings (New York: Random House, 1996), pp. 314–15.
Grant continued to warn investors about the stock market bubble in his investment newsletter, to provide detailed explanations of the cause of the bubble, and to chronicle the relevant statistics.
Another early analysis came from Tony Deden (1999) at Sage Capital Management, who identified the bubble and its causes and predicted a crash:
We fully expect a decline in securities prices and the almighty dollar over the next years. … There is no new paradigm. Economic sins have consequences. Hopefully, perhaps even economists will learn that inflation is measured by the growth in money and credit rather than in an idiotic index of consumer prices. They might even learn that growth achieved with smoke and mirrors ultimately leads to ruin.
Is the incredible rise in securities prices since 1995 a reflection of real value created or is it merely a bubble? Is this really a second Industrial Revolution that changes our very basic economic assumptions or is it not? Is it a “new paradigm”? A world of fast growth, record (low) unemployment and no apparent inflation? Have economic laws been suspended? And if not, how could so many people be so wrong?Anthony Deden, “Reflections on Prosperity,” Sage Chronicle, December 29, 1999.
Writing near the peak in the bubble, Deden declared with regard to the size and magnitude of the distortions:
Let there be no doubt, that what we are witnessing is, indeed, history’s greatest financial bubble. The indescribable financial excesses, the massive increase in debt, the monstrous use of leverage upon leverage, the collapse in private savings, the incredulous current account deficits, and the ballooning central bank assets all describe the very severe financial imbalances which no amount of statistical revision nor hype from CNBC can erase.Ibid.
He was equally clear and unequivocal about the cause of the bubble and related distortions in the economy:
Their cause is not the fault of capitalism as it has been suggested, but an excessive amount of money and credit created by central banks. Yet, this seems to escape the understanding of those who will, in one day, convene congressional hearings to determine what caused this destruction. The culprit is, as it always has been, the same organization, which professes interest in bringing about price stability and low inflation: The Federal Reserve Bank and its policies of money market intervention, credit creation and loose money.Ibid.
Economist Jörg G. Hülsmann, writing in August 1999, provided an analysis and prediction of the stock market bubble based on the post-1980 monetary regime in the United States. He concluded that the market boom had been created artificially and that it was doomed to fail:
You do not need a rocket scientist to predict the bitter end of this evolution. … Just as any other state of affairs that has been artificially created and maintained by inflation, the present system bears in itself the germs if its own destruction. It will experience a flat landing of which even the most recent crises in South-East Asia, Russia, and Latin-America only give a weak foretaste.Jörg Guido Hülsmann, Scöne neue Zeichengeldwelt (Brave New World of Fiat Monies). Postface to Murray Rothbard, Das Schein-Geld-System (Gräfelfing), p. 140.
Hülsmann discussed the alternative courses of action that the Fed might take to deal with the boom and bust in the stock market. The first is to continue inflating money and credit, the second to stop that inflation. However, he concluded: “In any case the crisis is therefore inevitable. It breaks out as soon as the price-enhancing effect of the inflation is no longer neutralized through currency exports or other factors. (And of course the crisis accelerates when the inflationary currency streams back from abroad).”Ibid., p. 147. From these arguments, he concluded that the system of boom and bust based on national fiat currencies must eventually come to an end and that either path of economic policy will entail extreme changes in our political economy:
It is but a question of time until North-America and Europe also reach the dead end of an economy built on fiat money. At that point, however, there will be nobody to extend the life span of this shallow game through further credits and further inflation. Either the western economies will then be under total government control, as it has already been the case in German National Socialism, or we are expecting a hyperinflation. It may take some more years or even decades until we reach this point of time. It can be further delayed through a currency union between Dollar and Euro (and Yen?). But it is and remains a dead end street, at the end of which there is either socialism or hyperinflation. Only radical free-market reforms — in Rothbard’s words: return to a commodity money such as gold on a free currency market and a complete ban of government from monetary affairs — lead us out of this.Ibid., p. 154.
If Hülsmann is correct, not just about the end of the bull market but about the economic and political consequences of the bust, then the issue of stock market bubbles, their cause, and their consequences takes on a critical importance for our understanding of the future course of the overall political economy.
Hülsmann is not the only economist who traced this business cycle back to the post-1980 monetary regime of deregulation. At the height of the bull market, allies of the Austrian school of economics held a conference at which most participants emphasized the role of the Fed in creating the boom. In particular, Frank Shostak highlighted the impact of the central bank’s policies:
Today’s prevailing view is that central banks and other policy makers are knowledgeable enough to pre-empt severe economic slump. … Notwithstanding the popular view, the US economy is severely out of balance. The reason for this is the prolonged loose monetary policies of the US central bank. The federal-funds rate which stood at 17.6% in April 1980 fell to the current level of 5%. At one stage in 1992 the rate stood at 3%. The money stock M3 climbed from $1824 billion in January 1980 to $6152 billion at the end of June 1999. In a time span of less than a decade it grew by over 200%. Another indicator of the magnitude of monetary pumping is the Federal debt held by the US central bank. It jumped to $465 billion in the first quarter of 1999 from $117 billion in the first quarter 1980, a 300% rise. Obviously the sheer dimension of the monetary pumping and the accompanied artificial lowering of interest rates has caused a massive misallocation of resources which ultimately will culminate in a severe economic slump.
The intensity of the misallocation of resources was further strengthened with the early 1980’s financial de-regulation. The idea of financial deregulation was to free the financial system from the excessive controls of the central bank. It is held that freeing financial markets will permit a more efficient allocation of economy’s scarce resources, thereby raising individual well being. It was argued that the overly controlled monetary system leads to more rather than less instability. Nonetheless, rather than producing more stability, the “liberated” system gave rise to more shocks.
The 1980’s financial de-regulation resulted in a reduction of the central bank supervisory powers. The weakening in the central bank controls gave impetus to a greater competition in the financial sector. This in turn through the fractional reserve banking sparked the unrestrained creation of credit and money out of “thin air.” The money out of “thin air” in turn has been further processed by creative entrepreneurs, who have converted this money into a great variety of financial products, thereby contributing to a wider dissemination of the monetary pollution.Frank Shostak, “Inflation, Deflation, and the Future,” Mises Daily, October 5, 1999.
On the basis of his analysis of the then-current economic utopia, Shostak concluded that the economy was poised for bad times ahead: “It seems therefore that the chaotic state of world financial markets will continue to get worse, unless gold is allowed to assume its monetary role. Notwithstanding that[,] there is very little reason for being optimistic in the current economic climate.”Ibid.
The most forceful prediction of both a stock market bubble and a stock market bust came from bearish economist George Reisman in an article published on August 18, 1999, at the height of the stock market bubble. He began with the observation that the conditions of reality were clearly askew, an observation that most market commentators made only in hindsight:
Clearly, something is wrong. It simply cannot be that we can have a society in which everybody lives by day trading in the stock market. While the stock market does make an important contribution to capital accumulation and the production of wealth, it is far from an unlimited one, and its contribution is not enlarged by hordes of essentially ignorant people dabbling in it on the basis of tips and hunches. Yet such an absurd outcome of practically everyone being able to live by means of buying stocks cheap and selling them dear is what is implied by an indefinite continuation of the bull market. As a result, it is inescapable that the bull market must end.George Reisman, “When Will the Bubble Burst?” Mises Daily, August 18, 1999.
For Reisman, predicting stock market bubbles and crashes is not a matter of measurement, but of cause and effect. He made the common sense observation that to understand the cause of a stock market bubble is to understand its ultimate effect: “To understand precisely how and when this will come about, one needs to understand what has been feeding the current bull market. Then one can understand what will put an end to it — what will constitute pulling its foundation out from under it.” He found the ultimate cause of extreme movements in the economy in general and in the stock market bubble in particular to be government intervention in connection with the money supply and interest rates: “The only thing that explains the current stock market boom is the creation of new and additional money. New and additional money, created virtually out of thin air, has been entering the stock market in the financing of corporate mergers and acquisitions and of stock repurchases by corporations.”Ibid. Shunning issues of technological change and psychology, Reisman concluded not only that excess financing for the stock market was the cause of the bubble, but that this money ultimately finds its way throughout the economy, spreading higher prices and bringing the stock market back to reality. He therefore separates technology and normal economic growth from inflation-financed bubbles in stock prices. Obviously, both phenomena occurred simultaneously and mingled during the 1990s:
The increase in the quantity of money exerts its favorable effect on stock prices only when, as in the last few years, the increase is concentrated in the stock market and has not yet sufficiently spread throughout the rest of the economic system. When it does spread throughout the economic system and begins substantially to raise commodity prices, the effect on the stock market becomes negative.
The application to the stock market is that the market will stop rising as soon as the Federal Reserve becomes sufficiently alarmed about the inflationary flooding of the economy as a whole that emanates from the stock market bathtub so to speak. When the Federal Reserve is finally moved to turn off the water — the new and additional money — flowing into the stock market, its rise will be at an end. Indeed, not only will the stock market stop rising, it will necessarily suffer a sharp fall.
The inescapable implication is that sooner or later, the stock-market boom must end. The bubble must break.Ibid.
Reisman, it appears, made an accurate analysis of the stock market, identified the cause of the bubble, and accurately predicted that the stock market would crash.For an updated analysis, see George Reisman, “It May Be Bursting Now, and Faulty Economic Analysis May Cost Investors Dearly,” Capitalism.net, February 26, 2000.
Economic and stock analyst Sean Corrigan also provided well-timed prognostication of the bubble and deep insight into its cause. He compared conditions during the fall of 1999 to those during the late summer of 1987, the Japanese bubble of the late 1980s, and the Roaring Twenties in the United States. He dismissed the idea that technology and a “new paradigm” could have been responsible for the run-up in stock prices in the late 1990s. In his view, debt of all kinds was expanding at high rates at a time when the saving rate was plummeting. The solution to this economic paradox was straightforward for Corrigan. He blamed Alan Greenspan for overly generous provision of high-powered money, and he then proceeded to explain the impact of this highly expansionary monetary policy:
Monetary pumping on this order, as the Austrians will tell you, leads to serious distortions in the price structure of an economy which cannot be captured in crude, aggregate, index numbers. These distortions between the value of goods, present and future, lead to mal-investments and a clustering of false decisions. Factories built and productive processes put in train based on a market rate of interest artificially lowered by the effulgence of fiduciary media are not backed up by real savings and thus become misaligned with a propensity for consumption which has, if anything, intensified.Sean Corrigan, “Will the Bubble Pop?” Mises Daily, October 18, 1999.
What effect do these distorted prices and investments have? Corrigan went on to make a bold and far-reaching prediction:
A raft of “entrepreneurial errors” lies ahead. This means not only the prospect of half-finished malls, hotels and offices, but also completed, now distinctly sub-par undertakings: businesses and plants which cannot possibly earn the returns projected at inception. Less visible, though more widespread, such an overhang will depress returns on capital where they do not wipe it out completely. The credit expansion, once it draws to its inevitable end, will impoverish everyone, everywhere.Ibid.
Writing at the end of the boom, bearish economist Hans Sennholz described both the direct cause (credit creation by the Fed) and its effects in creating the boom in both the stock market and the general economy, taking special note of the explosion in the use of derivatives:
Surely, the American economy looks very dynamic and the value of the stock market is the highest in U.S. history, but the private economy is incurring the biggest financial deficits since the Second World War. The country is suffering record current account deficits with net external liabilities now exceeding 20 percent of GDP and rising.
Wall Street may be celebrating the decline in government deficits, but other debts continue to grow by leaps and bounds. According to the Fed’s Flow of Funds, household debt (mainly home mortgages) is growing at an annual rate of 9.25 percent, total household debt as a share of personal income now exceeds 103 percent. Business debt is soaring at a 10.5 percent rate. Corporate debt of non-financial firms is rising at a 12 percent rate, the fastest in more than a decade.
While some of these debts are going into new investments, much is spent on share buybacks. In short, corporations are going into debt to boost their share prices. Margin debt in the stock market is growing faster than any other type of credit. In 1999 it soared by 46 percent, now exceeding $206 billion, which is the highest in U.S. history. Unfortunately, if this growth of debt should come to a halt, or merely slow down, it may break the fever of the boom and usher in the readjustment.Hans Sennholz, “Can the Boom Last?” Mises Daily, July 31, 2000.
Sennholz went on to describe the precarious position of the economy and the stock market. He described the contraction in the market as an inevitable consequence of the credit-induced boom and as something the Fed had no power to fix:
The American economy is in its 10th year of cyclical expansion, which is the longest on record. A grave risk in this setting is a sudden fall in share prices, a bear market, which would evoke a dramatic fall in consumer confidence and demand. Since consumption is driving more than two-thirds of American production and growth, a sharp decline of consumer demand would soon lead to a decline in production, which may trigger an international run from the dollar. In order to stem such a run and attract enough foreign capital to cover the current account deficit of more than 4 percent of GDP and carry external liabilities of more than 20 percent of GDP, the Federal Reserve would have to raise its rates. But such a raise at a time of falling stock prices and falling output would soon aggravate the decline and lead to a painful recession. The present pleasant scenario of rising productivity and income, high stock prices and a strong dollar would soon turn into the opposite — falling productivity and income, falling stock prices and a weak dollar, declining imports, rising inflation, rising interest rates, and rising unemployment. The longest economic boom in history would give way to a long recession.Ibid.
Just as clearly, the cause of the credit creation and therefore the boom is the Fed and the policy of central bankers:
The economic maladjustments due to many years of monetary manipulations by the Federal Reserve System are the prime source and mover of the inevitable readjustment. Once the market structure no longer reflects the unhampered choices of all participants, the readjustment is unavoidable. In the end, the laws of the market always prevail over the edicts of political controllers and regulators. They even reign over the wishes of a few central bankers. Surely, government officials and central bankers have the power to lessen or aggravate the stresses of readjustment as they have the power to interfere with the economic lives of their nationals.Ibid.
At a time when many were still unsure about the causes and consequences of the initial features of the bust, others such as William Anderson clearly saw the “beginnings of the end” and emphasized that this big cycle of boom and bust was nothing new to US economic history:
We have, supposedly, learned our lessons since the 1970s. Alan Greenspan knows more than previous Federal Reserve chairmen, Robert Rubin was a brilliant Secretary of the Treasury, the internet is providing new ways of doing business, and Bill Clinton has marvelously orchestrated the whole thing. The stock market is rising, and the government (or at least the current regime, according to Al Gore in his stump speeches) knows how to continue the prosperity. This time, we really are experiencing the New Economy.
Pardon me if I dissent. If history tells us correctly, we are in our third “New Economy” in the last 80 years. The first episode of “prosperity forever” came in the late 1920s, as the bull market, low unemployment numbers, and general good times led newly-elected President Herbert Hoover to declare, “In no nation are the fruits of accomplishment more secure.” We know the rest of that sorry story.William Anderson, “New Economy, Old Delusion,” Free Market 18, no. 8 (2000): 5.
Anderson was careful to distinguish the cause of the boom from the normal or natural features of economic growth. He also distinguished between a potential catalyst of the bust (the Microsoft trial) and its underlying causes:
But for all of the high-technology wonders and the gains made from deregulation, the one substantial part of the New Economy consists simply of an economic boom in all that the phrase implies. The engine behind the boom is also the locomotive behind the inevitable bust: the Federal Reserve and its inflationary policies.
As things stand currently, the once-vaunted bull market is in flux. This is partly due to the government’s arrogance in believing it could attack Microsoft without harming other high-technology firms that have been the most visible in the current economic expansion. That the NASDAQ has lost much of its value since Janet Reno’s Department of Justice [DOJ] won the first round of its attempt to dismember Microsoft bears testament to this administration’s foolishness regarding economic matters.
But even without the DOJ’s Microsoft follies, the high-technology sector of the economy faces real problems. First, the bubble that pushed so many of the “dot-com” initial offerings into the stratosphere had burst even before Reno’s pyrrhic victory. Second, the malinvestments as described by Ludwig von Mises and Murray Rothbard that occur as the result of wildly expansive monetary policies by the Fed have been centered in the high technology sector. The growth of new money that is the signature of inflation can come only through the fractional-reserve banking system in the form of loans, which, as noted earlier, have found their way into high technologies, real estate, and the stock market.
Should a large number of high technology investments go bust, or if profit rates disappoint potential investors, the new money will stop pouring into that sector. By that time, we will be seeing an increase of commodity prices, and inflation will be recognized as a serious problem. The next stage will be the beginning of the recession, as the malinvestments that grew willynilly during the period of monetary expansion will have to be liquidated.
The US economy the past five years has been able to absorb a large amount of new money, much more so than it could have done two decades ago. That does not mean, however, that it is inflation-proof or is impervious to malinvestments. The Misesian theory of the business cycle is a comprehensive theory. It has not lost its explanatory power in 2000 any more than it was irrelevant in 1969 or 1929.
While we may be currently celebrating a record boom, we have not overturned the laws of economics. No doubt when it happens, the usual Keynesians in the halls of academe and in the media will blame high interest rates and the Fed’s refusal to expand credit. In truth, there will be another explanation, one that people are ignoring now and will ignore then.Ibid., p. 6.
Supply-side economist Jude Wanniski (2000) attributed the bust in the stock market during April 2000 to tax liabilities accrued from capital gains in the late 1990s. Investors who had capital gains in 1999 had to pay taxes on those gains on April 15, and Wanniski suggested that investors selling shares in order to pay their taxes ignited the decline in the prices of the stocks composing the NASDAQ index. Although this observation provides insight into what might have initiated the bursting of the bubble, Wanniski himself did not believe in financial bubbles and encouraged his clients to jump back into the market after tax season was over.Jude Wanniski, “Letters to Clients,” March 30 to April 19, 2000.
Another important prediction came from economists Stan Liebowitz and Stephen Margolis, who were considering questions of competition and antitrust policy in high-technology markets. They correctly described these markets as displaying a speculative bubble near the apex of the bubble: “This is not to imply that a speculative bubble, which seems the proper description for Internet stocks as this book is being written [spring 1999], is required to assure sufficient financing.”Stan J. Liebowitz, and Stephen E. Margolis, Winners, Losers, & Microsoft: Competition and Antitrust in High Technology (Oakland, CA: Independent Institute, 1999), p. 115. Liebowitz later provided a more detailed examination (published after the bubble had burst) of why the bubble happened:
The book … focuses on understanding why financial events went so awry. … Many of the prognostications about the internet — rapidly increasing number of users, rapidly increasing advertising revenues, rapidly increasing sales — fertilized wildly optimistic prognostications for the performance of Internet firms, as if a virtual cornucopia of wealth would come streaming down upon investors in those companies [and it did for those lucky enough to get in early]. … But even if all the prognostications of users and revenue growth had been true, as some of them were, that would not have assured the rosy financial scenario that so many investors and analysts anticipated.Stan J. Liebowitz, Rethinking the Network Economy: The Real Forces That Drive the Digital Marketplace (New York: Amacom, 2002), p. 2.
Conclusions Such is the exuberance on Wall Street that only a brave man insists that the American stock market is overdue for a crash. Down the long history of bubbles ready to burst, it was ever thus. — Economist, March 25, 2000
The foregoing survey of predictions regarding the stock market bubble of the 1990s was conducted against a background condition that economists do not agree on either the role of prediction in economic science or the causes of stock market bubbles. The purpose was to identify who correctly ascertained the existence of a stock market bubble and who correctly predicted a stock market crash. The appendix at the end of this article provides a timeline of additional quotes reflecting insight, unawareness, or confusion regarding the macroeconomic contours of the bubble and the crash. More important, however, this survey has examined how the boom was identified and what its cause was. These issues are important because stock market booms and busts entail massive transfers and financial losses in the economy, and when associated with severe downturns in the business cycle, they can cause significant economic costs, distortions, and inefficiencies. Economic crises have often provided the occasion for a ratcheting upward of the size, scope, and power of government (Higgs 1987). In extreme cases, such radical changes in financial and economic conditions may give rise to social upheaval and political instability.
In general, the correct predictions fall into two categories. Those in the first group were based on the analysis of valuation. Using standard measures of stock market value, such as the price-to-earnings ratio, economists such as Robert Shiller and a small number of market analysts who were bearish in 1999 concluded that the stock market had become extremely overvalued and therefore was experiencing bubble-like conditions and was fated to decline steeply. Unfortunately, most of these forecasters did not provide detailed economic analysis of their predictions. The use of valuation measures is indeed helpful, but such measures are essentially only tools of historical analysis for comparing ratios and percentages from one time period to those from another period or to historical averages. In the recent bubble, most bulls always found a way to adjust the valuation measures to account for modern conditions and to make the stock market appear undervalued.
The second group of correct predictions came from outside the mainstream of the economics profession. Most came from economists associated with the Austrian school of economics, including academic economists, financial economists, and fellow travelers of the school. These predictions began to come forth in 1996 and continued until after the downturn in the stock market, but most of them occurred close to the peak in the stock markets. Austrians tend to have a negative view in general, and they are quick to emphasize the negative aspects of economic conditions, but they also distinguish bubbles and business cycles clearly from other economic phenomena and trends. Given that the Austrian economists are both relatively few in number and marginalized in the profession, their dominance in making correct predictions seems to be something of an elephant in the soup bowl, especially in light of their general disdain for forecasting and for the mainstream’s requirement of accurate prediction. In my survey, I tried to avoid the inclusion of “permabears,” or analysts who are perpetually bearish on the stock market. It should be noted, however, that James Grant is a self-admitted permabear and that his prediction came too early in terms of market timing. The predictions are summarized in table 2.
It is especially noteworthy that all the Austrian predictions provided an economic explanation of the bubble and that their explanations were relatively consistent across the group. To generalize, the Austrians perceived the Fed to be following a loose monetary policy that kept interest rates below the rates that would have prevailed in the absence of that policy. Individual writers emphasized the Fed’s willingness to bail out investors consistently during the 1990s, thereby desensitizing investors to risk. As a result, a period of “exuberance” and wild speculation took place, culminating in the hysteria of a stock market bubble. If the Austrian analysis is correct, the Fed has been a significant source of financial and economic instability. This analysis also suggests that the Fed’s bias toward keeping rates as low as possible may cause significant economic losses and that a better policy might be to let market forces determine interest rates without intervention.
Those who discovered the “boom” in the economy and the “bubble” in the stock market and who predicted either a “bust” in the economy or a crash in the stock market work within an analytical tradition dating back to Richard Cantillon, whose Essay on the Nature of Commerce in General was published in 1755. The Cantillon tradition was carried forward and extended in the works of Turgot, Say, Bastiat, Menger, Wicksell, Böhm-Bawerk, Mises, Röpke, Hayek, and Rothbard, and it is now a hallmark of the modern Austrian school of economics.
At the core of this mode of analysis is an emphasis on entrepreneurship and the study of what causes prices to rise and fall, encompassing wages, rents, profits, interest, and the purchasing power of money. With respect to the business cycle, the Cantillon tradition shows that disturbances in the supply of money and credit, especially when a monetary authority expands the supply of paper money, changes relative prices. Artificial reductions in interest rates encourage investment and increase the valuation of capital assets, longer-term assets increasing in value more than shorter-term ones. The resulting changes in the structure of production (buildings, technology, and the pattern of industrial organization) are called Cantillon effects. They occur during the boom, a phase when resources are misallocated, both to malinvestments and to misdirected labor. As relative prices correct themselves in the bust, resources are reallocated by mechanisms such as bankruptcy and unemployment. Capital-asset prices are extremely volatile during this process.
Although Austrian ideas have received more notice and attention in the financial media and in academic publications in recent years, a survey of economic textbooks at the undergraduate or graduate level would find hardly a word about Austrian business cycle theory or about Cantillon effects. It may be too early for a complete revision of economics textbooks and too much to ask that economics professors rewrite their class notes, but it certainly is time at least to introduce these concepts in classrooms and textbooks so that students can consider an alternative paradigm and evaluate its merits.
Appendix: Some Other Predictions Jerry Jordan: “The problem may … be … in asset [stock] markets, as suggested by historical episodes in this country, notably in the 1920s, and in Japan in the late 1980s.”Jerry J. Jordan, president of the Federal Reserve Bank of Cleveland in the minutes of the Federal Open Market Committee meeting, November 11, 1997. As a voting member of the Federal Open Market Committee, Jordan, president of the Cleveland Fed, voted unsuccessfully five times to raise interest rates, starting in 1998.Victor Zarnowitz: “The arguments in favor a [sic] new Golden Age are generally not persuasive.”Victor Zarnowitz, “Theory and History Behind Business Cycles: Are the 1990s the Onset of a Golden Age?” NBER Working Paper 7010 (Cambridge, MA: National Bureau of Economic Research), abstract. Zarnowitz is aware of the Austrian theory of the business cycle and considers it in his analysis.Lew Rockwell: “At some point, and nobody knows when, the stock market is going to reverse its climb. It may even collapse.”Llewellyn H. Rockwell, Jr. “Stock Market Bailout,” Free Market (November 1999): 4.Greg Kaza: “There is talk on Wall Street of a ‘New Economic Paradigm,’ that has repealed the business cycle. But surface appearances can be deceiving. … Eventually a recession will occur.”Greg Kaza, Greg, “Downsizing Detroit: Motown’s Lament,” Chronicles: A Magazine of American Culture (November 20, 1999), p. 20.Holman Jenkins: “The claim by Glassman and Hassett to have found a new value for the Dow is a wonderful marketing gimmick, but it is the least important part of their book. The authors are certainly right that Americans have gotten over their fear of the stock market — because the stock market works better than it used to. For investors, it has become safe to buy, hold, and forget.”Holman W. Jenkins, Jr., 1999–2000. “Of Bulls and Bubbles,” Policy Review 98 (1999–2000).Alan Greenspan: “I recognize there is a stock market bubble problem at this point,” and “I guarantee if you want to get rid of the bubble, whatever it is, [increasing margin requirements] will do it”.Alan Greenspan, minutes of the Federal Open Market Committee meeting, September 24, 1996.William McDonough: “I think the banking system is functioning just about where I would like it to be — that is, appropriate willingness to take risk but with good, sensible judgments in general being demonstrated.”William McDonough, president of the New York Federal Reserve, quoted by Reuters, September 26, 1999.The Economist: “Such is the exuberance on Wall Street that only a brave man insists that the American stock market is overdue for a crash. Down the long history of bubbles ready to burst, it was ever thus.”The Economist 2000, p. 84.Alan Greenspan: “It is very difficult to definitively identify a bubble [in US stock markets] until after the fact.”Alan Greenspan, speech at the Federal Reserve Bank of Kansas City’s annual conference at Jackson Hole, Wyoming, August 20, 2002.Nicholas Brady: “The present market collapse is different; it was caused by vastly overblown valuations. The stock market has been in a colossal bubble, a delusion born in the late 1990’s that reached its zenith in 2000. While not uncommon, bubbles have always been a fact of market life, a byproduct of runaway human emotions.”Nicholas F. Brady, “Every Market Collapse Is Different,” New York Times, August 11, 2002.Laurence Mayer: “There was a sense of frustration that we couldn’t deal better with the asset-price bubble. … But I don’t think anybody has come up with a strategy that people felt would have gotten the job done.”Federal Reserve governor Laurence Mayer as quoted in Carol Vinzant, “Two Schools of Thought on Economics,” Chicago Tribune, September 3, 2002.Matthew Spiegel: “The difficulty with declarations claiming that large stock price moves are ‘bubbles’ or ‘panics’ is that they rely on perfect hindsight, typically generated only a few months or a year following the event. But investors do not have that luxury. They must price securities based on the information they have at the time they make their decisions.”Matthew Spiegel, “2000 A Bubble? 2002 A Panic? Maybe Nothing?” Yale School of Management (New Haven, CT., 2002), p. 5.Robert Shapiro: “If not technology shocks or market pricing failures, what’s driving the current business cycle? It’s not terrorism or war. Terrorism doesn’t exact sufficiently large direct costs to drive the economy; and it’s hard to argue that its psychological effects have slowed growth, when the economy turned around in the quarter immediately following 9/11 and turned in its best performance in years in the quarter after that. Nor is there hard evidence that the prospect or reality of the war with Iraq punctured business investment and consumer spending.”Robert Shapiro, “Spin Cycle: Why Has the Business Cycle Gone Topsy-Turvy?” Slate.com. April 15, 2004.James Grant: “In the boom cycle, people are not so much interested in a message that says: a bust is simply a necessary part of the business cycle. In a false prosperity, good economic ideas are marginalized. That’s why Austrians should prepare right now to offer the best explanation when the tide turns, as it always does. Who knows? Maybe we’ll find ways to make the bust intellectually profitable. In time, Austrian economics could be again seen as the mainstream theory. It should be.”James Grant, “The Trouble with Prosperity: An Interview with James Grant,” Austrian Economics Newsletter 16 (1996): 8.
Preface During the 1980s Japan was feared as an economic and technological powerhouse. Most observers attributed their stock market bubble and high growth rates to easy monetary policy, management style, and government managed technological development. Since 1990, the Japanese government has been fighting price deflation with monetary inflation and trying to increase growth by government deficit spending. By all accounts it has not worked. Their economy remains mired in low growth, they have by far the highest ratio of government debt to GDP in the world, and they face a dramatic demographic crisis as their population continues to age. This chapter is the lesson of what NOT to do and who not to listen to for advice.
Business cycles and bubbles differ from one another, but the technical similarities between the Japanese and US bubbles are striking. The Japanese bubble began in the early 1970s, the US bubble started in the early 1980s. Both stock markets grew rapidly for thirteen years and then went parabolic to form bubbles, which peaked in Japan at the end of 1989 and in the United States during early 2000. Both stock markets lost about a third of their value eighteen months after their peaks. The Nikkei Stock Index has since lost as much as three-quarters of its peak value, while the Dow Jones Industrial Average has been down 40 percent and the NASDAQ Composite down by 75 percent of its peak value. The real estate bubble continued in Japan for some time after the stock market began its meltdown, and likewise, real estate — particularly housing — experienced (two) bubbles since the initial breakdown of the US stock market in 2000.
The surprising thing is that in the United States the lessons of the Japanese bubble seem to have almost gone unnoticed. Japan experienced fourteen years (now more than twenty-five years) of economic stagnation since its bubble popped. Most troubling, the United States not only failed to heed the warnings of the Japanese bubble, it has thus far mimicked Japan’s failed attempts to stimulate its economy with extremely low interest rates and large government budget deficits. Both countries have opted for a slow, agonizing “recovery,” rather than a sharp correction of past errors that would quickly reallocate resources and return the economy to sustainable growth. Experts tell us that the Japanese and their economy are very different from the Americans and their economy and that the Japanese bubble and Japan’s policy response to its crash were likewise different, but while there certainly are many important differences between the US and Japanese bubbles, the technical features and new-age thinking are strikingly similar in both bubbles.
For example, there is no doubt that technology and new-era thinking played a major role in the Japanese bubble. During the bubble, Japan took over leadership of high technology in the areas of consumer electronics, the automobile industry, manufacturing, and even robotics, and was perceived as a major threat to dominate all technological development around the globe — just as the United States is today. The threat posed by Japan’s growing technological prowess can be seen in the titles of books published during the bubble era: Japan’s High Technology Industries, edited by Hugh Patrick and Larry Meissner (1986); The Technopolis Strategy: Japan, High Technology, and the Control of the Twenty-First Century, by Sheridan Tatsuno (1986); A High Technology Gap?: Europe, America, and Japan, edited by Andrew J. Pierre (1987); The Science and Technology Resources of Japan: A Comparison with the United States, by Maria Papadakis (1988); Created in Japan: From Imitators to World-Class Innovators, by Sheridan M. Tatsuno (1990); Japan as a Scientific and Technological Superpower, by Justin L. Bloom (1990); Japanese Technology Policy: What’s the Secret? by David W. Cheney and William W. Grimes (1991); and Japan’s Growing Technological Capability: Implications for the U.S. Economy, edited by Thomas S. Arrison et al. (1992).
Writing near the pinnacle of the bubble in the stock market, Fumio KodamaFumio Kodama, Analyzing Japanese High Technologies: The Techno-Paradigm Shift (London: Pinter Publisher, 1991), p. 171. explained that the Japanese takeover of technological progress was a result of a new Japanese paradigm that was ushering in a new era:
Japan is becoming one of the frontrunners in industrial technology, which means that prominent science and technology policy researchers all over the world now pay more attention to Japan. Considering this change more deeply, one can understand the reason for the researcher’s academic interest: the paradigm of technological innovation is shifting.
KodamaIbid., p. 172. found that in Japan the innovation of high technology “seems to be different from that for conventional technologies,” and therefore studies focused on Europe and the United States would not lead to a “new scientific framework for analyzing innovation of high technologies.” He suggested that we break away from the inadequate linear model of the past to the unlimited model experienced under the unique “social and cultural context” of Japan. KodamaIbid., pp. 173–74. even ended his book with the suggestion that it was the Japanese cassette-tape recorder, VCR, and fax machine that made the Iranian revolution, Philippine revolution, and Tiananmen uprising possible. This is classic new-era bubble thinking.
Another component of modern new-era thinking is the belief that the so-called scientific management of the economy creates perpetual prosperity. Here the Japanese experience epitomizes this phenomenon because the Japanese economy was said to represent a new “third way,” positioned between the free market economy and that of the centrally planned economy. In Japan, government and corporations act cooperatively in both their self-interest and the general interest of the nation. Bureaucracies help plan and coordinate the economy. They provide incentives, such as financing and tax breaks, in order to channel investment in profitable directions. Corporations, in turn, participate in joint research programs with their competitors, but share the results among participating firms, with each choosing what technological advances to employ in their firms. Production planning is facilitated by an overlap of ownership between final-good producers and their input suppliers. Japanese management, especially during the bubble, was said to spur innovation, enhance product quality and reliability, and create large market shares in export markets for Japanese industries. Alas, none of this could prevent a meltdown of the Japanese stock market and well more than a decade (now more than a quarter century) of stagnation in the Japanese economy.
New-era thinking about the scientific management of the economy was never more prominent and bold than during the Japanese bubble of the 1980s. It was often said that the Japanese system would lead to economic dominance and threaten the preeminence of the US economy. Laura D’Andrea Tyson, who would later become chairman of President Clinton’s Council of Economic Advisors, outlined (at the apex of the bubble) the “threat” of Japan’s technological superiority:
Certainly Japan continues to obtain technology wherever it is available and to translate it into commercial advance, as the United States itself did for so long. However, now talk has begun of a new, “technoeconomic” paradigm emerging in Japan, a new trajectory of technological development. That trajectory emerged from a pattern of industrial catch-up shaped by policies of import substitution and export promotion. As Japan reaches industrial maturity in a broad range of industries, its government is exerting substantial efforts to build a Japanese position in advancing technologies. Agencies such as the Ministry of Trade and Industries (MITI), which have become familiar names in policy discussions in the United States, are involved.Laura D’Andrea Tyson, John Zysman, and Giovanni Dosi, “Trade, Technologies, and Development: A Framework for Discussing Japan,” in Politics and Productivity: The Real Story of Why Japan Works, edited by Chalmers Johnson, Laura D’Andrea Tyson, and John Zysman (Cambridge, MA: Ballinger Publishing, 1989), p. xiv.
In Japan, the government channeled research and development efforts, directed financing, and protected markets for business. This new, third way of government management of the economy was thought to be Japan’s source of economic strength and was to inevitably place it in a position of economic preeminence. As Tyson and ZysmanLaura D’Andrea Tyson, and John Zysman, “Preface: The Argument Refined,” in ibid., p. xiv. confidently asserted:
A generation from now, Japan will almost certainly have created its own mechanism for advancing the technological frontiers in a range of domains. Now the continuing pace of productivity increase suggests that Japan may indeed be on a growth trajectory different from that of the United States. As Japan ascends, America frets about its decline.
Tyson and her coauthors, Dosi and Zysman,Ibid., pp. 4–5. questioned the validity of traditional economic thought, as all new-era thinkers must. They justified Japan’s “often flagrant and self-aware violations of the nostrums of traditional economic thinking” because when “technological change is a key determinant of market outcomes, standard economic models that treat such change as exogenous are a poor guide to understanding the dynamics of market competition and the effects of policy on such competition.” They argued that the “nostrum” of economic efficiency should be abandoned in favor of the less constraining and poorly defined notions of growth efficiency and technological efficiency.
Leaving the anchor of economic efficiency and traditional economic thinking behind, Tyson, Zysman, and DosiIbid., pp. 14–15. were able to justify a variety of noneconomic policies such as “beggar thy neighbor” protectionism. She heralded the concept of growth efficiency, which is essentially a Keynesian idea that rests on the assumption “that there are always unutilized resources that can be mobilized to meet growing demand. … It is exactly this kind of thinking that led the Japanese to target industries whose products were perceived to have high income elasticities as a foundation for rapid economic growth.” Ignoring the economic condition of scarcity and grasping at the concept of an economy of perpetually unutilized resources is a precondition for new-era thinking, as well as a quintessential mistake of freshman college students taking their first course in economics. If resources are perpetually available then an unlimited amount of all goods and services can be produced and there are no economic problems to solve. This would seem to be the most basic of economic errors and a particularly grievous one to make in analyzing resource- and land-poor Japan.
Naturally Tyson also had to offer a rationale for why markets do not work, and she concluded that entrepreneurs will pass up more profitable long-run investments in order to pursue short-run profits under certain conditions. Tyson, Zysman, and DosiIbid., p. 17. even admitted that their argument was simply a variation of the long-discredited infant-industry argument for protectionism:
Under conditions of nondecreasing returns there is simply no way that markets can relate the varying future growth efficiencies of various industries to relative profitability signals facing individual producers. Basically, this argument is a variant of the infant-industry argument. Because of increasing returns, current market signals can be misleading indicators of future profitability. Consequently, government policies to promote a domestic industry with high future growth potential can improve economic welfare in the long run.
It would seem from the perspective of Tyson, Zysman, and Dosi that modern-day entrepreneurs might invest in the production of black-and-white television sets or mechanical typewriters made out of jute if not for the prodding and oversight of government bureaucrats.
In their justification of Japan’s new-era thinking, Tyson, Zysman, and Dosi viewed technology from the historical rather than economic perspective. In an age of information and communication technology, their “path dependent” and “sticky” processes of technological development seem odd and not entirely appropriate for new-age theorists, who often view technology as “spontaneous,” perfectly flexible, and ever present. Nevertheless, they clearly are new-era philosophers of the Japanese bubble and its new technological paradigm:
The expression technological paradigm … involves a new set of best practice rules and customs, new approaches to how to relate technology to market problems, new solutions to established problems. The notion of a major industrial transition, of a second industrial divide, of a shift from “Fordist to flexible” manufacturing that has become a fad in some debates points to just such a shift in technological paradigm.Ibid., p. 31.
In retrospect, the new-era thinkers of the Japanese bubble economy seem conceited and hopelessly naïve, but that is the power of bubbles to deceive. One of the few observers to correctly identify and characterize the bubble was Christopher Wood,Christopher Wood, The Bubble Economy: Japan’s Extraordinary Speculative Boom of the ’80s and the Dramatic Bust of the ’90s (New York: Atlantic Monthly Press, 1992), p. 255. who wrote that Japan “became so arrogant in the late 1980s because it really believed it was immune from the natural laws of the marketplace. This really was one of the most astonishing acts of mass delusion ever, and future historians … will marvel at it.” The Japanese people might be particularly susceptible to the delusions of a stock market bubble because their culture has so long emphasized honesty and respect for authority, and the government has carefully maintained the isolation of its people, both of which could contribute to herd-like behavior and which make them ripe for what Charles Mackay famously called “the madness of crowds.” The Japanese also have characteristics in their social psychology, as well as their well-known emphasis on precision and details, that might make them more susceptible to new-era delusions. The truth is that all these psychological characteristics are unimportant in terms of the cause of bubbles.
In the wake of the bubble and bust, Japan experienced a long series of corruption scandals, a procession of failed prime ministers, the ousting of financial ministers, the conviction of bureaucrats for corruption, and the breakup of its one-party system. However, the Japanese have failed to truly recognize the cause of their bubble and to liquidate their economic mistakes. Instead they embarked on a post-bubble course of easy credit, public works, and deficit spending that has only served to condemn the Japanese economy to continuing economic doldrums.
Postscript The success of Japan after WWII was due entirely to the free market economy, small government, low taxes, an appreciating currency, and a very high personal savings rate. That all changed when the bubble was born in the late 1980s because of overly stimulating monetary policy. A quarter century after the stock market meltdown Japan is still mired in an economic slump. At the prodding of mainstream economists, such as Paul Krugman, Japan has embarked on massive amounts of public works projects, enormous amounts of government borrowing, and extreme levels of monetary stimulus and quantitative easing. None of this has worked. It has left the country with the largest national debt relative to GDP in the world. It has also diverted the attention of the Japanese people and thus prevented the country from addressing its demographic crisis. In fact, it might have made the demographic crisis worse. After all, why get married and have children when the children will have to bear the enormous burden of the national debt?
[The original version of this chapter was published as “Housing: Too Good to Be True,” Mises Daily, June 4, 2004.]
Signs of a “new era” in housing are everywhere in 2004. Housing construction is taking place at record rates. New records for real estate prices are being set across the country, especially on the East and West Coasts. Booming home prices and record-low interest rates are allowing homeowners to refinance their mortgages, “extract equity” to increase their spending, and lower their monthly payment! As one loan officer recently explained to me: “It’s almost too good to be true.”
In fact, it is too good to be true. What the prophets of the new housing paradigm don’t discuss is that real estate markets have experienced similar cycles in the past and that periods described as new paradigms or new eras are often followed by periods of distress in real estate markets, including foreclosure sales, bankruptcy, and bank failures.
The case of Japan’s real estate bubble is instructive. Japan had a stock market bubble in the 1980s that was very similar to the US stock market bubble in the 1990s. As the Japanese stock market started to bust, Japan’s real estate market continued to bubble. One general index of Japanese real estate shows that prices rose for almost two years after the stock market crashed, with prices staying above pre-crash levels for more than five years. The boom in home construction continued for nearly six years after the stock market crash. Prices for commercial, industrial, and residential real estate in Japan continues to fall and are now below the levels measured in 1985 when these statistics were first collected.
It has now been three years since the US stock market crash. Chairman Greenspan has indicated that interest rates could soon reverse their course, while longer-term interest rates have already moved higher. Higher interest rates should trigger a reversal in the housing market and expose the fallacies of the new paradigm, including how the housing boom has helped cover up increases in price inflation. Unfortunately, this exposure will hurt homeowners, and the larger problem could hit the American taxpayer, who could be forced to bail out the banks and government-sponsored mortgage guarantors who have encouraged irresponsible lending practices.
More Greenspan Once again, Fed chairman Alan Greenspan“Testimony of Chairman Alan Greenspan.” Federal Reserve Board’s Semiannual Monetary Policy Report to the Committee on Banking, Housing, and Urban Affairs, US Senate, February 12, 2003. has created a new-age economic panacea, and earlier this year he applauded his contribution to the economic recovery: “Very low interest rates and reduced taxes, have permitted relatively robust advances in residential construction and household expenditures. Indeed, residential construction activity moved up steadily over the year.”
The key to this panacea is the process of equity extraction that occurs when people refinance their homes; they take equity out and spend it to increase their standard of living. However, because variable-rate mortgages are so low, their payments actually go down, so they have more of their monthly income to spend or they can upgrade to a more expensive house. As Greenspan explained:
Other consumer outlays, financed partly by the large extraction of built-up equity in homes, have continued to trend up. Most equity extraction — reflecting the realized capital gains on home sales — usually occurs as a consequence of house turnover. But during the past year, an almost equal amount reflected the debt-financed cash-outs associated with an unprecedented surge in mortgage refinancings.Ibid.
As is the norm, Greenspan hedged his statements. He also considered some of the potential drawbacks and pitfalls on the horizon for the new paradigm in housing, but in the end he concluded that we really have nothing to worry about. Low interest rates, rising home prices, and lower financing costs mean that we actually can have our cake (i.e., our homes) and eat it too (i.e., equity extraction for consumption):
To be sure, the mortgage debt of homeowners relative to their income is high by historical norms. But as a consequence of low interest rates, the servicing requirement for the mortgage debt of homeowners relative to the corresponding disposable income of that group is well below the high levels of the early 1990s. Moreover, owing to continued large gains in residential real estate values, equity in homes has continued to rise despite sizable debt-financed extractions. Adding in the fixed costs associated with other financial obligations, such as rental payments of tenants, consumer installment credit, and auto leases, the total servicing costs faced by households relative to their incomes are below previous peaks and do not appear to be a significant cause for concern at this time.Ibid.
The Housing Bubble I first reported on the housing bubble in the United States at the beginning of this year (2004) when the bubble was already well under way, if not in full bloom. As the chart “Real Private Residential Fixed Investment” in chapter 18 indicates, real residential investment has jumped far above both its historical trend and even its cyclical trend channel. This indicates to me that there is a bubble in residential real estate. The data for this chart originally stopped at the beginning of 2003. We now know that investment in housing increased by 8.8 percent last year. This is a historically high rate of construction, but far from a record rate increase. However, 2003 marks the ninth year in a row that housing investment was positive, the first time that has ever occurred since the statistic has been collected. Frank ShostakFrank Shostak, “Housing Bubble: Myth or Reality?” Mises Daily, March 4, 2003. and Christopher MayerChristopher Mayer, “The Housing Bubble,” Free Market 23, no. 8 (August 1, 2003). have also written very informative articles on the housing bubble.
Recently I came across a piece of anecdotal evidence of a housing bubble. Last Sunday afternoon, a friend of mine put a “For Sale by Owner” sign on the front lawn of a small rental house he owned on a side street. It wasn’t listed with a real estate agent or in the newspaper, but he nonetheless had a couple of calls that afternoon, with many more to follow, and within a couple of days he had multiple offers before he finally accepted a bid that was substantially over his original asking price.
Mainstream economists who discount the possibility of a housing bubble would dismiss such evidence. But they also ignore all the macro evidence of the current housing boom and see it as a positive development. For example, the number of new homes being constructed is at an all-time high, despite a “soft” labor market. The annualized rate of new home construction has surpassed the two surges of the 1970s when inflation was out of control.
The prices of houses are also up circa 2004, but mainstream economists have generally ignored this development as well; and as noted above, Greenspan sees this as a positive development. Some economists can even point to the Consumer Price Index, which shows that the housing component in the CPI is steady or falling. And yet reports are coming out nearly every day saying that housing prices are up dramatically and setting records all across the country. Record prices have been recently reported in the San Francisco Bay Area, Denver, Boston, Las Vegas, the State of Washington, and even Buffalo, New York.
Nationally, the price of a median family home was up 15 percent between 2001 and 2003, with regional increases of 30 percent in the Northeast, 8.5 percent in the Midwest, 14.4 percent in the Southeast, and 20.4 percent in the West. Over the last year, increases have been reported as 18.7 percent in the Northeast, 1.9 percent in the Midwest, 3.8 percent in the Southeast, and 10.7 percent in the West, or 6.5 percent for the nation as a whole. Interestingly, the median price has actually dropped 7.2 percent in the Midwest and 7.3 percent in the South since peaking in the third quarter of 2003, while prices have been generally flat in the West. Statistics from the last couple of quarters might therefore suggest that the housing bubble may have topped out, or at least temporarily cooled down, in much of the country.
Why have home prices been increasing? David Lereah, chief economist with the National Association of Realtors, explained to Inman News (2004): “It’s a simple matter of supply and demand. … We continue to have more home buyers than sellers in most of the country, which results in tight housing inventories and higher rates of home price appreciation.”David Lereah, “Real Estate Prices Post Double Digit Gains,” Ocala Star-Banner, May 22, 7, 2004. Of course the cause of higher home prices is that the Federal Reserve has kept interest rates, and thus mortgage rates, at historically low rates such that people find it easier to finance homes. In fact, despite an 18 percent increase in home prices since 2001, the median monthly payment remained the same at $789/month and the median payment as a percentage of income has actually fallen. This is the magic of monetary inflation, courtesy of Alan Greenspan.
Price Inflation Follows Monetary Inflation The price of just about everything I buy is going up these days. Gasoline is higher, dairy products are higher, paper products and just about everything else — higher. Mainstream economists have sounded surprised by the recent upturn in price inflation, and they have offered us every excuse to ignore signs of inflation: Ignore rising oil prices. Ignore rising food prices. Ignore rising health care costs. Ignore higher taxes and government fees. And then there is their dirty little secret about housing prices.
Higher price inflation should not have been a surprise given that the Fed has increased the money supply by 25 percent during the period 2001–3. In addition, the price of basic commodities has been rising for many months, and these higher commodity prices eventually turn up in the price of goods and services. One leading indicator of higher commodity prices is the Dow Jones Commodity Index, which represents the stock prices of major commodity producers. It has been rising since the fourth quarter of 2001 and has doubled in value since that time. This stock index is now higher than it has ever been, outside of the blip that occurred in mid-2002.
Only recently have commodity prices begun influencing government price indexes like the Producer Price Index and the Consumer Price Index. For the first four months of 2004 CPI inflation increased at an annual rate of 4 percent, which is a higher rate than we have experienced in the last few years. The Producer Price Index actually decreased in 2001, but has increased in 2002 and 2003. During the year ending June 2004, prices for finished producer goods increased 3.7 percent, while at earlier stages of production the prices for intermediate goods increased by 5.1 percent and the prices of crude materials surged 20.4 percent. This would suggest that there is potentially plenty of price inflation still in the pipeline. The experience of the 1970s would suggest that price inflation adds fuel to housing bubbles because tangible assets such as homes serve as a hedge against inflation.
The Dirty Secret While this price inflation did not surprise me, the delay in its arrival did — that is, until I came across the dirty little secret in the CPI. With prices increasing all around us, there is one thing in Auburn, Alabama, that seems to be in abundance with stable, if not declining, prices. This “good” is now being advertised on most streets throughout the town, whereas in the past it did not require much, if any, advertising over the twenty-plus years I have lived in this college town. This abundant good is housing.
It is a truly odd market when houses and apartments move in opposite directions. After all, houses and apartments are just different products in the same market for housing. In Auburn, it is nearly impossible to find the kind of house you want to buy despite frantic building by construction companies, and yet rental properties, which include many smaller houses, seem to be readily available in all shapes and sizes. Has the population changed? Have people become antirent? Or are we just in a “new housing paradigm”? Is this a “new era” of homes?
Greenspan’s low interest rates have driven renters to become homeowners and knocked the market out of equilibrium. Underneath this Fed-inspired distortion rests the dirty little secret of how the cost of housing has served to limit increases in measured inflation. The Consumer Price Index has underreported price inflation because the government uses the rental value of housing, rather the actual price of houses, in its index.
In the basket of goods used to calculate CPI, the goods that have increased slower than housing include food and beverages, recreation, and education, which add up to about 30 percent of the weight in the CPI basket of goods. Housing accounts for 42 percent of the basket, with housing prices representing almost 25 percent of the entire basket. However, housing prices are calculated with “owner’s equivalent rent,” which is an estimate of the rent that people would have to pay for their houses. With home prices rising and rental rates stagnant, the CPI underestimates the real rate of price inflation over the last year (circa 2004) by about 50 percent.
Do Housing Bubbles Burst? Housing prices never, or rarely, go down. That is the conventional wisdom, and the conventional wisdom is correct. Housing is always a good investment, isn’t it? It’s an inflation hedge and it’s an investment that you get to use every day, plus you get a great tax break. And the home, after all, is a big part of the American dream, right?
Government can screw up just about anything. Given enough power and time it will screw up everything. Housing and real estate in America is just the latest example. The Federal Reserve and the Mac-Mae family of government-sponsored enterprises that facilitate various kinds of debt (i.e., Freddie, Fannie, Sallie, etc.) have conspired to create a housing bubble in the United States, and as the old saying goes, “What goes up must come down.” It’s only a matter of time.
Housing bubbles typically do not pop like a balloon; they don’t even crash like stock markets. Rather, the air in housing bubbles tends to leak out slowly — painfully slowly — while in commercial real estate markets there is a more noticeable hiss. We really don’t know the current value of our homes until we sell them. They are not traded on a daily basis, like shares of stock in Walmart. Some never get exchanged in the market, but are passed on within a family from generation to generation. The market value of a home may drop 20 percent and the owner might never realize it.
Worse yet, when the market for real estate collapses, prices are less likely to collapse because when buyers fail to make offers houses simply don’t sell. Sellers often resist cutting their prices in favor of just leaving the house on the market or taking it off the market. Traditionally the market adjustment to a collapse in real estate markets has come from the quantity side, not the price side — fewer houses are sold — while price reductions tend to come gradually. This doesn’t mean that housing bubbles can’t exist or that the bust is any less painful, only that it doesn’t make the same noise as a crash.
It is difficult to predict how long bubbles will last and when they will go bust. The best indicator is interest rates, because when the Fed forces rates down it tends to create bubbles, and when rates are forced upward bubbles tend to pop. My guess is that Greenspan will raise rates after the election.
Prior to this spike, interest rates had been falling since the early 1980s. As mentioned above, lower rates have coaxed people into refinancing their homes and extracting equity from their homes to spend on other purchases, such as cars, boats, renovations, vacations, or even investments in the stock market. As a result, owner equity as a percentage of real estate value is now at an all-time low.
Here is the unmentioned problem with Greenspan’s panacea. What happens to all these “equity poor” homeowners if the return of monetary inflation establishes a new trend of higher prices and higher interest rates over the coming years?
An ever-increasing proportion of mortgage financing has come in the form of variable-rate mortgages, where the payment increases as interest rates increase. In my experience, variable-rate mortgages come with a “cap” that only allows the variable rate to increase by a certain amount. Even with the cap, however, your mortgage payment could increase by around 50 percent. I have recently learned that many variable-rate loans are now offered without a cap. If rates were to explode upward, mortgage payments for these folks could double or triple. And if this did happen, the housing market would collapse with sellers swamping buyers.
Given the government’s encouragement of lax lending practices, home prices could crash, bankruptcies would increase, and financial companies, including the government-sponsored mortgage companies, might require another taxpayer bailout.
Of course inflation might not materialize. Interest rates could stay low. I reported on a new book Deflation: What Happens When Prices FallChris Farrell, Deflation: What Happens When Prices Fall (New York, 2005). that even predicts that deflation will rein in our financial future. Greenspan has suggested that his economic panacea has given American homeowners greater economic “flexibility.” I would suggest that it is not flexibility he offers, but the shackles to an economic nightmare. Stick with the fixed-rate mortgages, keep the equity in your homes, or go get one of those cheap apartments.
[This chapter originally appeared as “The Economics of Housing Bubbles,” in Housing America: Building Out of a Crisis, edited by Randall G. Holcombe and Benjamin Powell (New Brunswick, NJ: Transactions Publishers, 2009), pp. 237–62. Reprinted with permission from the publisher.]
Nothing better illustrates government failure and the housing crisis than the housing bubble. While the housing bubble is being created by government, homes become increasingly expensive and beyond the economic reach of first-time home buyers. Then as interest rates rise and housing prices fall, many home buyers find themselves with bad investments that they can no longer afford. What started as a grand federal-government effort to improve homeownership for all Americans through a policy of “easy money” will have unintended consequences that will leave many Americans economically scarred for the rest of their lives. An easy-money policy involves the central bank (the Fed) setting low interest rates and expanding the money supply so that it is easier to get credit (loans), and it also involves government-sponsored credit organizations such as Fannie Mae and Freddie Mac that make getting home mortgages easier.
When an economic bubble pops, many people are harmed economically. In the case of a housing bubble, this will be especially true of homeowners, particularly new homeowners who buy homes during the peak phase of the housing bubble. However, the harm also consists of unemployment of labor and a loss of value to owners of capital, particularly in housing-related industries. At the individual level many people are forced into bankruptcy. On the macroeconomic level the bursting of the housing bubble can send the overall economy into recession or depression. Housing bubbles concentrate their impact in the home-building, materials and furnishings, real estate sales, and mortgage businesses.
On top of all that, people suffer psychological consequences as well. The people most involved in the bubble are confident, jubilant, and self-assured due to their apparently successful decision making. When the bubble bursts they lose confidence, go into despair and lose confidence in their decision making. In fact, they lose confidence in “the system,” which means they lose confidence in capitalism, and become susceptible to new political “reforms” that offer structure and security in exchange for some of their autonomy and freedoms.
The reason economic crises create fear and concession of liberty is that people do not generally know what caused the bust or economic crisis and generally do not even know that there was even a bubble in the first place. In fact, as the bubble bursts many people deny that there is a problem and believe that the whole situation will quickly return to what they consider normal. The average citizen thinks very little about what makes the economy work, but simply accepts the system for what it is, and tries to make the most of it.
The purpose of this chapter is to show how “the system” works, how it generates bubbles, why they eventually burst, and the macroeconomic effects of bubbles. Here we apply the economic understanding of bubbles derived from Austrian business cycle theory, or ABCT, to the current 2006 case of the housing bubble and show that this aspect of the housing crisis is the result of government failure — the inevitable failure of a government bureaucracy (i.e., the Fed) to manage the money supply and interest rates in an economically rational manner. However, the same reasoning can be applied to historical bubbles, from the tulip mania in seventeenth-century Holland to the dot-com tech bubble of the late 1990s, as well as to future bubbles.
What Causes Housing Bubbles? There are three basic views of bubbles that are held by economists and the general public. The dominant view among the general public and modern mainstream economists, including the Chicago school and proponents of supply-side economics, is to deny the existence of bubbles and to declare that what are thought to be “bubbles” are really the result of “real” factors. The second view, which is espoused by Keynesians and by proponents of behavioral finance, is that bubbles exist because of psychological factors such as those captured by the phrase “irrational exuberance.” The third and final view is that of the Austrian school, which sees bubbles as consisting of real and psychological changes caused by manipulations of monetary policy. This view has the advantage of being forward looking and identifying an economic cause of bubbles. By identifying an economic cause it also directs us to policy choices that would prevent future bubbles.
Most people agree with the majority of economists that there is no such thing as a housing bubble — housing prices, they say, “never go down.” Supply siders and Chicago-school economists seem to view the declaration of a bubble as an affront to homo economicus — economically rational man — because they view it as an assertion of some psychological flaw in people that requires government intervention.Homo economicus is the model of the rational economic person that economists use to build their models and theories about the economy. This assumption asserts that people are rational and will always attempt to maximize their utility. This is a source of contention and misunderstanding among economists and between economists and other social scientists. They note that if there were a rational cause or causes of housing bubbles, or any type of bubble for that matter, then even if only some people believed it was a bubble, they could profit by selling homes at inflated prices and deflate the bubble long before it ever became overinflated and burst. Furthermore, if housing bubbles had irrational foundations, then certainly an economically rational man could profit enormously by shedding light on the erroneous psychological motivations that were causing the bubble.
Although there is much diversity in this camp, it is well illustrated by two economists from the Federal Reserve Bank of New York who examined concerns about the existence of a speculative bubble in the US housing market. While McCarty and Peach did find that a housing bubble could have a severe impact on the economy — if it existed and were to burst — they ultimately concluded that such fears were unfounded:
Our main conclusion is that the most widely cited evidence of a bubble is not persuasive because it fails to account for developments in the housing market over the past decade. In particular, significant declines in nominal mortgage interest rates and demographic forces have supported housing demand, home construction, and home values during this period.Jonathan McCarthy and Richard W. Peach, “Are Home Prices the Next ‘Bubble’?” FRBNY Economic Policy Review (December 2004): 2.
Furthermore they find “no basis for concern” for any severe drop in housing prices. They found that when the United States has gone into recession or experienced periods of high nominal interest rates, any price declines have been “moderate”; and they found that significant declines can only happen regionally such that they would not have “devastating effects on the national economy.”
This is essentially the view of Alan Greenspan and Ben Bernanke. In particular, Greenspan was aware of the possibility of a housing bubble, but he offered every possible reason why it did not exist, and how if one did exist it would not be a major problem. The chairman is usually difficult to interpret and at times so incomprehensible as to be almost misleading. His testimony before Congress has been labeled “Greenspam.”Mark Thornton, “Surviving GreenSpam,” LewRockwell.com, February 16, 2004. However, on the topic of the housing bubble he is clear and direct and worth quoting at length:
The ongoing strength in the housing market has raised concerns about the possible emergence of a bubble in home prices. However, the analogy often made to the building and bursting of a stock price bubble is imperfect. First, unlike in the stock market, sales in the real estate market incur substantial transactions costs and, when most homes are sold, the seller must physically move out. Doing so often entails significant financial and emotional costs and is an obvious impediment to stimulating a bubble through speculative trading in homes. Thus, while stock market turnover is more than 100 percent annually, the turnover of home ownership is less than 10 percent annually — scarcely tinder for speculative conflagration. Second, arbitrage opportunities are much more limited in housing markets than in securities markets. A home in Portland, Oregon is not a close substitute for a home in Portland, Maine, and the “national” housing market is better understood as a collection of small, local housing markets. Even if a bubble were to develop in a local market, it would not necessarily have implications for the nation as a whole.Alan Greenspan, “Monetary Policy and the Economic Outlook,” Testimony before the Joint Economic Committee of the US Congress, April 17, 2002.
As the bubble approached its peak, GreenspanAlan Greenspan, “Mortgage Banking.” Speech to the American Bankers Association Annual Convention, Palm Desert, CA, September 26, 2005. did admit that there was some “apparent froth” in some local housing markets, but overall he found that conditions in the housing market were “encouraging.” In his first speech after leaving office Greenspan said that the “extraordinary boom” in the housing market was over, but that there was no danger and that home prices would not decrease.Joe B. Bruno, “Former Fed Chair Says Housing Boom Over,” Associated Press, May 19, 2006. The new Fed chairman, Ben Bernanke,Ben Bernanke, “Reflections on the Yield Curve and Monetary Policy.” Remarks before the Economic Club of New York, March 20, 2006. admitted the possibility of “slower growth in house prices,” but confidently declared that if this did happen he would just lower interest rates. Bernanke also believed that the mortgage market is more stable than in the past. Bernanke noted in particular that “our examiners tell us that lending standards are generally sound and are not comparable to the standards that contributed to broad problems in the banking industry two decades ago. In particular, real estate appraisal practices have improved.”Ben Bernanke, Speech to the Independent Community Bankers of America National Convention and Techworld, Las Vegas, NV, March 8, 2006.
A second view of housing bubbles and bubbles in general is that they exist, but that they are fundamentally caused by psychological factors. Many people and many important economists subscribe to this view of bubbles, including Keynesian economists and proponents of behavioral finance, such as Robert Shiller. From this perspective the business cycle is seen as the ebb and flow of mass consciousness and emotions. Real factors may play a role, but the important causal factors for deviations in the business cycle are psychological. Booms develop because people become confident and then overconfident in the economy. Investors likewise are confident and increase their tolerance for taking risk. Rising profits and asset prices lead to “speculative” behavior where economic decisions are no longer based on old rules and procedures, but on the bravery instilled by a “new era.”All of our actions involve some speculation about the future. Here “speculative” behavior refers to actions that involve great risks which are unwarranted based on the normal or known fundamentals of the economy. For example, betting on a round of golf with your friend involves some speculation and uncertainty, but past experience provides some guidance to the risks you are taking. Here, betting on a round of golf with Tiger Woods would be “speculative.” As the investment mania sets in, the bubble expands. Then, for whatever reason, people begin to lose faith and new investments are exposed as disappointing. Economic reports and statistics turn sour, and stories of scandal begin to appear in the press.It is a common misconception that corporate scandal is the source of bubbles and that it was companies like Enron and WorldCom that tricked investors during the late 1990s to bid up the stock markets to such high levels. It is true that scandal is a common feature of bubbles, but scandal could never account for more than a small percentage of bubbles, and in reality scandal is caused by the same source as the bubble itself — the existence of cheap and abundant credit that must be allocated to increasingly risky and suspect investments. Many investors remain determined in thinking that this turn of events is only temporary, but results grow worse, prices continue to fall, and investment projects are postponed, halted, or cancelled. The mood of the market is one of gloom or even doom. The economy enters a depression.
Representing the behavioral-finance camp is Professor Robert Shiller of Yale University, who is the author of Irrational Exuberance, the first edition of which correctly predicted the stock market bubble; the second edition predicted the housing bubble, whose “ultimate causes are mostly psychological.” Like the Keynesians to follow, ShillerRobert Shiller, “Are Housing Prices a House of Cards?” Project-Syndicate.org. September 2004. does not deny the existence of real factors; he simply downplays them in order to emphasize psychological factors. With the case of the housing bubble he finds three important factors. First, the increased risk and chaos in the world since the technology bubble and the terrorist attacks of 9/11 have caused a flight of investment into quality and safety — your own home. Second, the explosive growth in global communications has increased the glamour appeal of living in one of the world’s leading cities such as Paris, London, New York, or San Francisco. The third psychological factor is “the speculative contagion that underlies any bubble.” Here one higher price begets another, and higher prices in one city lead to higher prices in another city, and the process of higher prices simply builds on itself. Shiller declared that the first two factors will remain in effect, but the third factor cannot last forever. Once prices begin to drop, the contagion works in the downward direction and can last for years before the process is reversed again.
Representing the Keynesian camp is Paul Krugman, who is an economics professor at Princeton University and a writer for the New York Times. Krugman did not predict a housing bubble, but he did finally realize that we were in one and that it presented a big problem for the US economy. Commenting on the hectic pace of housing construction and the “absurd” housing prices Krugman drew parallels to previous investment manias: “In parts of the country there’s a speculative fever among people who shouldn’t be speculators that seem all too familiar from past bubbles — the shoeshine boys with stock tips in the 1920’s, the beer-and-pizza joints showing CNBC, not ESPN, on the TV sets in the 1990s.”Paul Krugman, “Running Out of Bubbles,” New York Times, May 27, 2005.
It is also correct to connect the phenomenon of day traders of technology stocks in the late 1990s to the house flippers of the housing bubble. The real question is: what causes this irrational behavior? Krugman suggested that, with the housing bubble, the bubble builds on expectations of capital gains:
So when people become willing to spend more on houses, say because of a fall in mortgage rates, some houses get built, but the prices of existing houses also go up. And if people think prices will continue to rise, they become willing to spend even more, driving prices still higher, and so on. … [P]rices will keep rising rapidly, generating big capital gains. That’s pretty much the definition of a bubble.Paul Krugman, “That Hissing Sound,” Ocala Star-Banner, May 22, 7, 2004. New York Times, August 8, 2005.
Notice that Krugman placed his emphasis on a supposedly unfounded change in taste or demand (“when people become willing to spend more on houses”) but downplayed the actual cause of the change in the demand for housing (“say because of a fall in mortgage rates”), as if anything might have ignited the bubble. The more Krugman tried to provide an economic rationale for the bubble the more he sounded like the Austrian economists who dominate the third and final view of the housing bubble. Another possible example of this is Baker and Rosnick,Baker and David Rosnick, Will a Bursting Bubble Trouble Bernanke? Evidence for a Housing Bubble (Washington, DC: Center for Economic and Policy Research, November, 2005). who demonstrate the case for a housing bubble and do so in a manner similar to Austrian economists; and even though they date the beginning of the bubble to 1997 they ignore the real factor that tax-law changes in that year were a catalyst to housing and higher housing prices. In fact, KrugmanKrugman, “Running Out of Bubbles.” cites fellow Keynesian Paul McCulley, who did correctly predict the housing bubble and did so in the manner typical of Austrian economists, where interest rate cuts lead to higher home prices, a construction boom, and higher consumer spending all based on increased debt — and he explicitly placed the blame for the bubble on the Fed. The problem with Keynesians such as Krugman and McCulley is that their cures — discretionary monetary and fiscal policy — usually make matters worse. Even if they could be made to work perfectly it would create a conundrum for Keynesian economists because a highly stabilized economy desensitizes investors to risk and makes them “irrationally exuberant” and thus creates the prerequisite for bubbles. Even Alan GreenspanAlan Greenspan, “Reflections on Central Banking,” speech given at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, WY, August 26, 2005. has warned, in his own convoluted way, that “history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”
As you can see, the first view wishes to dismiss psychological reasons for bubbles to focus only on real factors, while the second view wishes to downplay real factors in order to emphasize psychological causes. The third view believes that there are changes in both real factors and market psychology during bubbles and that both are driven by the cause of the business cycle — policy manipulations by the Federal Reserve. This view of bubbles is based on Austrian business cycle theory. This is a minority view held by Austrian-school economists and some fellow travelers of the school.A fellow traveler is someone who sympathizes with or supports various tenets of the Austrian school without being an acknowledged member or embracing all aspects of Austrian economics.
According to ABCT, if the Fed does not pursue a loose monetary policy then bubbles like the technology stock bubble of the late 1990s or the one in housing that we are now experiencing would not develop. If the Fed does follow a loose monetary policy, then a bubble can develop somewhere in the economy, whether it be in tulip bulbs, stocks, or real estate. If the new money is directed toward housing, a bubble will develop in housing. Austrian economists further emphasize that the additional resources allocated to housing are resources that are not available elsewhere in an economy, so that while more resources than normal are allocated to housing construction, fewer resources are available to other areas of the economy such as manufacturing, which will experience higher costs for its inputs such as labor and materials and will produce a proportionately smaller output. It is this mismatching of resources across industries and sectors that has to be resolved — painfully — in the inevitable bust or correction.
In a real estate bubble the price of existing homes rises. The bubble also fuels the construction of new homes so that the wages of construction workers rise and labor reallocates itself into construction and related industries. The bubble also increases the price of construction materials and land. Construction and construction-related industries are also where the most unemployment occurs and where the biggest price and wage declines occur in the inevitable bust. Another unique feature of the Austrian approach is that they do not see a need for prices to increase uniformly across markets, or for prices to increase to extreme levels in all markets. Many doubters of the housing bubble point to the smaller price increases in the center of the country compared to coastal regions, but price is only one dimension of bubbles — quantity can also increase beyond sustainable levels. In fact, one could conceptualize a bubble where prices stayed the same and all the bubble adjustment occurred only in the quantity dimension. If we doubled the number of houses and prices barely budged, we would be left with too many houses for the population and all the labor and materials that went into the production of those goods (i.e., houses) would be tied up and unavailable to serve more urgent needs after the bursting of the bubble revealed that the superfluous houses were bad investments.
Among the Austrians who identified the housing bubble is economist Frank Shostak, who defined a bubble as any activity that “springs up” from loose monetary policies: “In other words, in the absence of monetary pumping these activities would not emerge.” As a result of this pumping, a misallocation of resources develops whereby nonproductive activities increase relative to productive activities — something that seems to clearly characterize the US economy since he wrote in early 2003: “The magnitude of the housing price bubble is depicted … in terms of the median price of new houses in relation to the historical trend between 1963 and 1979. In this regard the median price stood at 73 percent above the trend in December 2002.”Frank Shostak, “Housing Bubble: Myth or Reality?” Mises Daily, March 4, 2003.
The only “problem” with his warning is that it came too soon. A year later Shostak warned that there “is a strong likelihood that the US housing market bubble has already reached dangerous dimensions.”Frank Shostak, “Who Made the Fannie and Freddie Threat?” Mises Daily, March 5, 2004. While early warning maybe a problem for investors in home building stocks, the problems of predicting the timing and magnitude of bubbles and business cycles affects all forecasters, and Shostak’s warning was primarily for the purpose of judging public policy. In effect he was noting that policymakers have made a mistake that they should correct immediately and not make the situation in the housing market any worse.
Also from the Austrian camp is banker Christopher Meyer, who noted that there is always a bubble in the making in a world of fractional reserve banking and fiat currency, and that housing has often been impacted by bubble conditions in the United States and elsewhere. In the summer of 2003 he identified the current housing bubble:
The strong housing market has all the makings of being the next bubble — in particular high leverage and unsustainable price increases. While the larger economy seems to sputter along, the housing market continues to run a hot race. Low interest rates have propelled refinancing, freeing up $100 billion last year alone, according to the Wall Street Journal. Not surprisingly, the low interest rates have increased buying power and supported housing prices.Christopher Mayer, “The Housing Bubble,” Free Market 23, no. 8 (August 1, 2003).
In early 2004 I pointed investors to the on-going housing bubble and specifically that it might not be a good idea to increase your mortgage: “It might not be a good time for you to obtain a home equity loan to invest in hot tech stocks. We are going through a housing bubble.”Thornton, “Surviving GreenSpam.” I followed this up later that year with a more detailed examination of the housing bubble and found:
Signs of a “new era” in housing are everywhere. Housing construction is taking place at record rates. New records for real estate prices are being set across the country, especially on the east and west coasts. Booming home prices and record low interest rates are allowing homeowners to refinance their mortgages, “extract equity” to increase their spending, and lower their monthly payment! As one loan officer explained to me: “It’s almost too good to be true.” In fact, it is too good to be true.Thornton, “Housing: Too Good to Be True.”
The problem with the “new era” diagnosis is that it ignores the historical fact that the housing market, and the construction of structures in general, has experienced regular cycles of boom and bust, with prices rising and falling for residential, commercial, industrial, and agricultural real estate. Likewise occupancy and lease rates, new construction, and the fate of construction firms and land speculators point us to the history of real estate bubbles. In fact, statistically, housing starts are a leading indicator of the business cycle and home construction is procyclical (i.e., home construction is positively related to changes in the overall economy, but more volatile). The Skyscraper Indicator even shows that historically the building of a record-setting high skyscraper foreshadows severe negative changes in the economy.Mark Thornton, “Skyscrapers and Business Cycles,” Quarterly Journal of Austrian Economics 8, no. 1 (Spring 2005): 51–74.
What Goes Up… ABCT demonstrates that monetary inflation has different effects depending on who receives the new money first and how it is spent. Is the new money introduced into the economy in the areas of banking and investment, consumer loans, or directly to a group of consumers or producers? Do the people who receive the money want to save it or spend it? If they save it interest rates will go down, and if they spend it interest rates will go up as entrepreneurs borrow money in order to increase production. If the money is spent, it depends on who is spending it. The economy will experience different changes if the money is given to welfare recipients instead of military generals. If the money is saved the economy will experience different changes than if it is invested in stocks rather than housing. The point here is that monetary inflation can cause bubbles and booms in the areas of the economy where it is first introduced. This foundation of ABCT comes down to us from Richard Cantillon, the founder of economic theory, who wrote in the aftermath of the Mississippi Bubble circa 1720s. Tracking the flow of monetary inflation through the economy is very difficult, and most mainstream economists just assume away the problem and declare that money is neutral on the economy.
By the end of the eighteenth century the world had converted from free banking to central banking, with the United States being the last major nation to establish a central bank in 1913. In the first treatise on monetary theory in the modern era, Ludwig von Mises produced the foundations of ABCT.Ludwig von Mises, The Theory of Money and Credit (Indianapolis, IN: Liberty Classics [1908] 1981). With central banks established for the purpose of producing monetary inflation, Mises could now establish a general theory of business cycles rather than the case-by-case basis of Cantillon. By integrating the contributions of Carl Menger, Eugen von Böhm-Bawerk, and Knut Wicksell he was able to show that when the central bank — the Fed — increases the supply of money, it causes the market rate of interest to fall below the natural rate of interest that would have existed in the absence of Fed intervention. This would cause investors to borrow more money, to expand their investments, and to undertake riskier projects and more roundabout production processes. As these borrowers compete for assets, resources, and goods, price inflation inevitably occurs and the rate of interest will increase. This in turn will negatively affect the economy, and some of the riskier and more roundabout investment projects will be discovered to be bad investments. Bankruptcies can also impact previously existing investments and production processes that are caught in the wake of the bust. Mises student F. A. Hayek expanded ABCT to include capital theory and its integration into the structure of production.
According to ABCT, when a central bank makes loans or purchases government bonds from banks it is injecting bank reserves into the economy. Banks now have excess reserves that they can loan, but the existence of excess loanable funds means that banks must reduce the interest rate they charge, reduce the credit-quality requirements of borrowers, or both. The result is a greater quantity of borrowing and investing, particularly in projects that “pay off” over a long period of time. Lower interest rates also discourage savings because the return from savings is lower. In this manner the Federal Reserve drives the market rates of interest below the natural rate of interest that would have existed in the absence of Federal Reserve intervention.
Ever since the Depository Institutions Deregulation and Monetary Control Act of 1980 and Paul Volcker’s (chairman of the Fed from 1979 to 1987) war on inflation of the early 1980s, interest rates have been on a downward path. This culminated with the large reductions in the federal funds rate that followed in the aftermath of the 9/11 terrorist attack in 2001. Under Greenspan the rate was reduced from 6.5 percent in November 2000 to 1 percent in July 2003. The federal funds rate remained at 1 percent until June 2004, coinciding with the launching of the final phase of the housing bubble. The Philadelphia Housing Sector Index peaked at the end of August 2005. At this low level, interest rates were negative when price inflation is taken into account.
The federal funds rate, which is the rate that banks can borrow from other banks in order to meet their reserve requirements imposed by the Fed. The Fed “targets” this short-term rate and injects reserves into this market by purchasing government bonds from banks, thereby freeing up reserves in the banking system. This essentially is the engine of inflation because the Fed simply makes a bookkeeping entry in the bank’s account with the Federal Reserve — modern inflation is essentially an electronic bookkeeping entry. The low rates of the 1960s resulted in no recession and a booming economy, but those low rates also caused the stagflation of the 1970s, where both price inflation and unemployment were very high. This culminated in Volcker’s war on inflation of the early 1980s. By greatly reducing expectation of price inflation and deregulating the banking system, the Fed has been able to reduce interest rates and ignite a giant boom in financial and asset markets throughout the 1980s and 1990s, as well as the housing bubble of the early 2000s when rates were clearly pushed below their natural levels and when rates were negative, when adjusted for inflation.
When banks have access to bank reserves from the Fed at low rates they can offer their customers lower rates on loans. The impact of changes in the federal funds rate has a direct impact on mortgage rates: increasing during the 1970s and peaking during Volcker’s war on inflation at 18 percent, and then generally declining throughout the 1980s and 1990s and then reaching historical lows during the early 2000s. During the housing bubble interest rates on thirty-year conventional mortgages were at their lowest levels ever during the post–gold standard era. When interest rates fall, asset prices and real estate prices tend to rise, and vice versa.
Naturally, lower rates for home mortgages have stimulated borrowing for real estate purposes. Total real estate loans first exceed $1 trillion in early 1995, reached $2 trillion in late 2002 and reached $3 trillion in early 2006 (the maximum for the bubble occurred in mid-2009 at $3.8 trillion). In addition to the Fed, there were other factors that helped direct all this new credit money into real estate. First, in 1997 homeowners were given a $250,000 exemption ($500,000 for couples) for capital gains that resulted from the sale of their house, adding greatly to the tax benefits of homeownership. This tax break could be said to have lit the fuse of the housing bubble. Second, government-sponsored credit corporations such as Fannie Mae and Freddie Mac, which can acquire capital at a subsidized rate because of the implicit assumption that the federal government will bail them out, began to collateralize home mortgage debt on a grand scale so that lenders could quickly and easily resell the loans they make. These government-sponsored agencies have helped stimulate the flow of credit to riskier borrowers who might not otherwise have access to credit, and have therefore helped to lower the credit standards of lending institutions. The problem with these institutions is so large that even Alan Greenspan has publically scolded them.Kathleen Hays, “Greenspan Steps Up Criticism of Fannie: Fed Chief Says Company and Freddie Mac Have Exploited Their Relationship with the Treasury,” CNN.com, May 19, 2005. In truth, the original problem lies with Alan, not Fannie or Freddie.
The artificially low rates generated by the Fed also have the effect of discouraging people from saving money and encouraging them to borrow more for consumption and speculation. The impact of monetary pumping by the Fed has driven down the personal savings rate throughout the 1980s and 1990s, and during the early 2000s it has driven the rate to zero — and even below — which means people are spending more than they earn. Contributing to the problem of the low personal savings rate are the artificially inflated asset and real estate prices which naturally make people feel wealthier and allow them to “cash out” equity from their homes when they refinance their home mortgages. During the housing bubble many Americans used their homes as a kind of giant ATM to withdraw cash from the equity in their homes. Others used the “magic checkbook” from second mortgages to spend the equity they had in their homes.Carol Lloyd, “Home Sweet Cash Cow: How Our Houses Are Financing Our Lives.” SFGate.com, March 10, 2006.
At this point one should be wondering — how could borrowing be going up and savings going down? One answer to the question is that America was borrowing money from overseas in the form of the trade deficit, but the main answer is monetary pumping by the Fed. By artificially lowering rates via increases in the money supply the Fed created a giant gap between borrowing and saving. MZM (money of zero maturity) is a relatively new measure of the money supply and one that is close to the Austrian-school definition of money, which is that it is immediately redeemable at par. MZM includes currency, demand deposits — that is, checking accounts — traveler’s checks, savings deposits, and deposits in money market mutual funds. During the period from January 1959 to August 1971 (11.7 years), when Nixon took the United States off the gold standard, the money supply grew by 82.2 percent for an average annual growth rate of 5.26 percent. Between August 1971 and 1984, when complete decontrol was established from the Depository Institutions Deregulation and Monetary Control Act of 1980 (13 years), the money supply increased by 180.4 percent for an average annual growth rate of 8.25 percent. Ever since 1984 (16.6 years) the money supply as measured by MZM grew by 390.1 percent, or an average annual growth rate of 10 percent. It would seem that all this new money first went into the New York Stock Exchange, especially during the 1980s, then the NASDAQ stock market during the late 1990s, and finally into the housing market after the dot-com bust in 2000.
A large part of the increase in the money supply found its way into the market for home mortgages. Since the recession of 2001 the increase in mortgage debt was about equal to the increase in MZM. This one stylized fact probably best illustrates the housing bubble and its cause. Another measure of the housing bubble is the amount of real private residential fixed investment. Investment in housing was low during the Great Depression and WWII, but beginning in the mid-1940s investment in housing, adjusted for price inflation, has shown a positive trend, which is based on economic and population growth over that same period. The cycle in housing investment was less severe before we went off the gold standard, more severe on the fiat standard, and even more severe after monetary deregulation in 1980. Most noteworthy is that investment in housing hit a boom high during the dot-com bubble of the late 1990s and then “jumped higher off the historical trend” during the recession of 2001, when historically it would have retreated back toward recessionary trend levels. It therefore seems clear that in terms of investment value there has been a housing bubble since at least the recession of 2001.
ABCT does not rely on measuring the cycle or bubble, but empirical measures do often help illustrate the approach. The next such measure is the number of homes built (apartments and other multiunit structures are not included here). Typically there are sharp downturns in the number of housing starts often coincide with the beginnings of recessions and that the sharper the drop the longer the recession. For example, in the late 1970s the number of housing starts fell from an annual rate of over 1.5 million to a rate of barely 0.5 million in the early 1980s, which was a severe recession. Since the recession of 1991 the trend in new housing starts has been steeply upward, and there was no noticeable downturn in housing starts during the recession of 2001 — the only recession on record where that did not occur. Instead housing starts continued to increase and have set several new records over the last few years. In terms of this quantity dimension the United States has been in a housing bubble since the early 2000s.
The final dimension of the housing bubble presented here is the price of houses. Doubters of the housing bubble claim that housing prices are rising on the East and West Coasts, but are not rising by bubble proportions in much of the center of the country. Of course housing prices have increased faster in the West and Northeast compared to the Midwest and South, but ABCT theorists would be shocked if home prices were rising uniformly across the country — after all the whole theory is based on changing relative prices, not uniform increases or decreases in a price level. There are microeconomic and public policy reasons why home prices rise more dramatically and are always at a higher level in, for example, California than they are in Alabama. These issues are explored in many of the other contributions to Powell and Holcombe.Holcombe and Powell, Housing America: Building Out of a Crisis. However, the same could be said about stock prices during the technology bubble — rare stocks in tight supply (e.g., dot-coms) did much better than widely held stocks (e.g., stocks in the DJIA). The same was true of tulip bulbs during the tulip mania that happened in seventeenth-century Holland — rare species were affected more by monetary conditions than ordinary species, but they all went up in price.Douglas E. French, “The Dutch Monetary Environment during Tulipmania,” Quarterly Journal of Austrian Economics 9 (Spring 2006): 3–14.
ABCT expects prices in general to rise, but not to rise uniformly. The extent of the rise depends on both where the money is being injected and the flexibility of the supply side of the markets where the injections are taking place. However, if we look at the national price index for the typical 1996 one-family house between 1998 and 2005 we find that prices have increased by 45 percent, which is a 125 percent larger increase compared to the increase in the Consumer Price Index. According to the Bureau of the Census, the price of the average house, as opposed to the “typical” house, has been increasing even faster, which indicates that people are buying bigger, more expensive homes as well. The price dimension — while muted somewhat by the economy’s ability to produce greater quantities of housing — still indicates a large increase in the real price of housing. We should also remember that new housing is generally built on lower-priced land, that house-building technology has reduced building costs, and that the large influx of labor from Mexico has also helped hold down costs.
… Must Come Down ABCT shows that it is government failure that started the housing bubble in the first place. This is where resources are allocated in an incorrect and ultimately unsustainable fashion. In a housing bubble too many houses are built, houses of the wrong sort are built, and houses are built in the wrong locations based on the underlying fundamentals of the economy and people’s real desires for housing not artificially stimulated by monetary inflation by the Fed. While most people are very happy during boom times, the Austrian economists view the boom as the real problem because this is where resources are misallocated. This is also when people become financially overextended and engage in excessive luxury spending.Thomas Kostigen, “Skewed Views: If the Rich Are Doing So Well, How Much Worse Off Are the Rest of Us?” MarketWatch, May 23, 2006. Inflationary periods tend to be when the rich get richer and the poor get poorer.
The bubble must come to an end because it is based on an irrational allocation of resources caused by the Fed’s misleading interest rate policy. Money that is tied up in an asset bubble initially prevents monetary inflation from being revealed as price inflation as measured by the Consumer Price Index. However, if the monetary pumping is used to purchase assets like stocks, bonds, or real estate then the inflation is revealed in the price of those assets, which will rise even though the underlying earnings of the assets have not improved. When money begins to leak out of asset bubbles into consumption, then the price of goods that are used to determine price indexes will begin to rise. The asset bubble is popped or deflated when interest rates rise. This can occur when either the market raises rates due to rising inflation premiums on loans or when the Fed tries to curtail increases in the Consumer Price Index by preemptively raising rates.
The bursting of the bubble reveals the cluster of errors in the housing market and related industries and begins the process of reallocating resources to their best uses by changes in prices, buying and selling, relocation, bankruptcy, and unemployment. The macroeconomic effect of deflating the bubble is that it causes the economy to go into recession or depression. However, the effects of the bubble will also be concentrated as it deflates. Note that the bubble in employment in the construction industry began in 1997 when it rose above a trend level, which dates back to the end of WWII. Note too that the trend in construction employment has always been negative during recessionary periods — even the recession of 2001 — and that the negative trends often extend beyond the periods identified as recession. Given that the trends in construction employment have been so strong for so long during the housing bubble, it would not be surprising that the negative impact of the bubble would take on a similar but negative effect on construction employment and spending, and that these effects would spread beyond to the construction-materials industry, mortgage lending, real estate sales, furniture, appliances, and household-goods items.
Another natural concern about the bursting of the housing bubble is the indebtedness of the average American. As we previously have shown, the personal savings rate of Americans has been declining for many years, in part because Americans have felt wealthier due to the rising price of their real estate properties. This is then coupled with the rising debt of the average American household. Total household debt was less than $500 billion when the United States went off the gold standard in 1971. It first exceeded $5 trillion in 1996 and $10 trillion in 2004. In October 2005, the last reported period, total debt exceeded $11.5 trillion. Certainly these figures could be adjusted for inflation, population, and economic growth, but that does not negate the fact that Americans have taken on a large amount of debt, but have not set aside a similar amount of savings to offset this debt or to insulate themselves from periods of economic distress.
As the economy goes into recession and unemployment increases, homeowners with large mortgages will have a difficult time making their monthly payments and may face the possibility of bankruptcy. This “squeeze” will be compounded by the fact that many homeowners have taken equity out of their homes in recent years, increasing the size of their mortgage. Further difficulties are presented by the fact that a large percentage of borrowers have taken out variable-rate mortgages rather than fixed-rate mortgages, which means that their monthly payment will rise and will rise substantially when interest rates increase. There are variable-rate mortgages where the payment stays the same, but this entails the principal on the loan increases when rates rise, which could place these borrowers “upside down” or “underwater” on the homes, which means the mortgage would be much larger than the value of the home. Lenders have also been providing mortgage loans based on much smaller down payments, in percentage terms, with some lenders even providing loans that exceed 100 percent of the price of the house. All of this points to the likelihood of a large number of foreclosures and bankruptcies. This in turn points us to the stability of the banking and mortgage-lending industries and the likelihood of a taxpayer bailout of banks and government-sponsored institutions such as Freddie Mac that buy mortgage loans from lenders.
Summary and Conclusions There are three views of the housing bubble. The mainstream view does not believe in bubbles and attributes such changes in the economy to real factors such as technology shocks, and believes there is nothing the government can do to solve such real problems. The Keynesian view is that bubbles exist because of psychological instabilities in the economy, not real factors, and that countercyclical policies of the government should be used to tame the business cycle. ABCT incorporates real and psychological changes into a view where bubbles are caused by the policy manipulation of the Federal Reserve.
The housing bubble that began in the late 1990s is a classic example of government failure as applied to the housing crisis. Inflation of the money supply that accompanied the Fed’s cheap-credit policy led to a borrowing and building binge of an unprecedented scale. The number of new homes built, the price of new and existing homes, and the total amount of real estate investment all indicate that the Fed policy, combined with a favorable tax policy and taxpayer-subsidized lending practices, created the housing bubble.
The bubble is not just a bunch of hot air. Real resources are involved, which have been misdirected during the bubble and which will cause painful adjustments in the aftermath of the bubble. This will involve unemployment, foreclosure, and bankruptcy for many people, especially those in the construction and construction-related industries. The macroeconomy will be sent into a recession or depression, which could be of a lengthy duration because of the slowness of the housing market as compared to the stock market, which can process very large changes in value within the period of one market day.
The lesson of the housing bubble is that what at first appeared to be the government’s trying to help improve homeownership for Americans has been a giant government failure and will have the unintended effect of economically scaring many homeowners, particularly those who bought houses at the peak of the bubble. Others have been fooled into extracting equity from their homes, increasing their mortgages, and taking loans, such as variable-rate loans, that they believed were necessary to qualify to buy houses at inflated prices. Similar trends in housing have occurred in countries around the world as many of the world’s central banks have been engaged in monetary pumping that has been injected into their housing sectors.
The policy lesson of the housing bubble, as provided by ABCT, is that the Fed is responsible for the housing bubble as well as the normal booms and busts in the economy, that it must be relieved of its authority to set what are in effect price controls on interest rates, and also be relieved of its control over the money supply. Furthermore, all federal policy toward housing should be guided by the principles of neutrality, laissez-faire, and do no harm.
Postscript — August 8, 2009 The housing and financial crisis discussed in this chapter is now well underway and we may well have entered the worst global economic crisis of this generation. The question of how economic policy will address these problems has also been revealed in that the Federal Reserve and the US Treasury have initiated aggressive and unprecedented policy responses. Under the cover of preventing a financial market meltdown, these policy responses are really attempts to bailout the owners of large financial business. They will do little to help the housing market and will increase the overall economic harm of the housing bubble.
Will policy responses continue to be aggressive and unprecedented in the direction of greater government centralization and power as the economic crisis worsens? The importance of this question goes beyond any measure of economic harm because it can result in fundamental changes in society. It could of course result in correct economic reforms such as the abolition of the Federal Reserve, the restoration of the gold standard, and the abandonment of Federal government subsidies to housing, but as I wrote in the initial draft of this chapter in June of 2006, which the editors asked me to remove:
On top of all that, people suffer psychological consequences as well. The people most involved in the bubble are confident, jubilant, and self-assured by their apparently successful decision making. When the bubble bursts they lose confidence, go into despair and lose confidence in their decision making. In fact, they lose confidence in the “system,” which means they lose confidence in capitalism and become susceptible to new political “reforms” that offer structure and security in exchange for some of their autonomy and freedoms.
In this manner, great nations of people have given away their liberties in exchange for security. The Russians submitted to Communism and the Germans submitted to National Socialism because of economic chaos. In 20th century America, economic crises — and fear more generally — provided the justification for the adoption of “reforms” such as a central bank (i.e. the Federal Reserve), the New Deal, the Cold War, and even fiat money during the economic crisis of the early 1970s.Robert Higgs, Crisis and Leviathan: Critical Episodes in the Growth of American Government (New York: Oxford University Press, 1987) shows how crisis (such as war or depression) lead to large increases in the size of government that were only partially offset by cutbacks after the crisis was over. On the final page of the book Higgs correctly predicted that future crises would include terrorism in addition to war and depression.
Fear of terrorism after 9/11 resulted in a massive transfer of power to government at the expense of individual liberty.Robert Higgs, Resurgence of the Warfare State: The Crisis Since 9/11 (Oakland, CA: Independent Institute, 2005) correctly predicted (in the days immediately after 9/11) that among other things that government would greatly expand its power “particularly surveillance of ordinary citizens.” Submission of liberty and individual autonomy in exchange for security and the “greater good” is now often referred to as choosing the dark side.A crisis is a crossroad or turning point where the decision maker can make the correct or incorrect choice. The wrong, fear-driven choice is now often referred to as choosing the “dark side” à la Star Wars movies. See Mark Thornton, “What Is the ‘Dark Side’ and Why Do Some People Choose It?” Mises Daily. May 13, 2005.
The reason economic crises create fear and submission of liberty is that people do not generally know what caused the bust or economic crisis and generally do not even know that there was even a bubble in the first place. In fact, as the bubble is bursting many people will deny that there is a problem and believe that the whole situation will quickly return to what they consider normal. The average citizen thinks very little about what makes the economy work, but simply accepts the system for what it is, and tries to make the most of it.
Increased government intervention in housing markets and the virtual socialization of the Government-Sponsored Entities (GSEs such as Fannie Mae), and the risk of mortgage-backed securities indicates that this dangerous trend will continue.
To reiterate, the Austrian business cycle theory (ABCT) shows that artificially low interest rates produce systematic distortions in the economy. The most important of these distortions is the inducement to build longer structures of production and more roundabout production processes involving advanced or premature technologies. It is during the resulting boom when all the mistakes or malinvestments occur in a temporal cluster. The bust or economic crisis is when these errors are later revealed. While ABCT has been under critical internal review,See Jeffrey Rogers Hummel, “Problems with Austrian Business Cycle Theory,” Reason Papers 5 (Winter 1979): 41–53, and Jörg Guido Hülsmann, “Towards a General Theory of Error Cycles,” Quarterly Journal of Austrian Economics 1, no. 4 (1997): 1–23. more recent worksJoseph T. Salerno, “Comment on Gordon Tullock, ‘Why Austrians are Wrong About Depressions,’” Review of Austrian Economics 3 (1988): 141–45. Reprinted in Joseph T. Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2010), pp. 325–31; William Barnett and Walter Block, “On Hummel on Austrian Business Cycle Theory,” Reason Papers 30 (Fall 2008): 59–90; Mihai Macovei, “The Austrian Business Cycle Theory: A Defense of Its General Validity,” Quarterly Journal of Austrian Economics 18, no. 4 (2015): 409–35. have found that ABCT has a “general validity.”
Although it is very difficult to model ABCT empirically, several empirical investigations have taken place with supportive results.C. Wainhouse, “Empirical Evidence for Hayek’s Theory of Economic Fluctuations,” in Money in Crisis, edited by B. Siegel, (San Francisco: Pacific Institute for Public Policy Research, 1984), pp. 37–71; P. le Roux, and M. Levin, “The Capital Structure and the Business Cycle: Some Tests of the Validity of the Austrian Business Cycle in South Africa,” Journal for Studies in Economics and Econometrics 22, no. 3 (1998): 91–109; James P. Keeler, “Empirical Evidence on the Austrian Business Cycle Theory,” Review of Austrian Economics 14, no. 4 (2001): 331–51; Robert F. Mulligan, “A Hayekian Analysis of the Term Structure of Production,” Quarterly Journal of Austrian Economics 5, no. 2 (2002): 17–33, and “An Empirical Investigation of the Austrian Business Cycle Theory,” Quarterly Journal of Austrian Economics 9, no. 2 (2006): 69–93. ABCT has also been proven useful in analyzing historical business cycles.A.M. Hughes, “The Recession of 1990: An Austrian Explanation,” Review of Austrian Economics 10, no. 1 (1997): 107–23; Jeffrey M. Herbener, Herbener, “The Rise and Fall of the Japanese Miracle,” Mises Daily, September 20, 1999; Benjamin Powell, “Explaining Japan’s Recession,” Quarterly Journal of Austrian Economics 5, no. 2 (2002): 35–50; Gene Callahan, and Roger W. Garrison, “Does Austrian Business Cycle Theory Help Explain the Dot-Com Boom and Bust?” Quarterly Journal of Austrian Economics 6, no. 2 (Summer 2003): 67–98; Patrick Newman, “The Depression of 1873–1879: An Austrian Perspective,” Quarterly Journal of Austrian Economics 17, no. 4 (Winter 2014): 474–509, and “The Depression of 1920–1921: A Credit Induced Boom and a Market Based Recovery?” Review of Austrian Economics (January 2016): 1–28.
The Austrian answer for the economic crisis is similar to the RBCT’s (real business cycle theory) rejection of the effectiveness of stimulative fiscal policy and monetary policy. However, ABCT does have a “positive” side to it. In general, government should follow a philosophy of laissez-faire. First, stop the inflation, raise interest rates, and achieve market-determined interest rates. Second, do not enact any policy that attempts to reduce bankruptcy or unemployment. Third, do not attempt to interfere with prices, wages, consumption, and saving.
This would allow the market’s corrective process to proceed at a fast pace to end the economic crisis quickly. On the active positive side, government should cut its budget, its taxes, and all types of regulations and prohibitions in order for more resources to be used productively and efficiently in the private sector. Following these policy recommendations would result in an economic crisis that is painful, but short.
The opposite policy approach to laissez-faire, which employs bailouts and monetary and fiscal stimulus, results in economic crises that are much more painful and prolonged. Examples of this include the Great Depression, the stagflation of the 1970s, Japan’s lost decade(s), and the current financial crisis. The Austrian policy approach tends to hurt the wealthy relatively more than the middle and lower income classes, while mainstream policy approaches tend to hurt the middle- and lower-income classes and to help the rich.
When interest in ABCT by the general public increased significantly after the housing bubble burst, it was largely ignored by mainstream economists. Eventually some economists started to make criticisms that were more like witticisms, such as when Nobel Prize–winning economist Paul Krugman labeled ABCT the “hangover theory.” More recently ABCT has experienced multiple attacks by notable mainstream economists. This could be a good sign if you believe in an idea often attributed to Mahatma Gandhi: “First they ignore you, then they ridicule you, then they fight you, and then you win.”
Criticisms of the Hydraulic Version of ABCT The hydraulic version of ABCT is the one described by Gottfried Haberler.Gottfried Haberler, Prosperity and Depression: A Theoretical Analysis of Cyclical Movements (Lake Success, NY: United Nations, 1937). It could be described as a mainstream translation of ABCT as developed by Mises, Hayek, and Rothbard, with several critical divergences. Nevertheless, this version was surprisingly seized upon by economists in order to criticize ABCT.Tyler Cowen, “Paul Krugman on Austrian Trade Cycle Theory,” Marginal Revolution, October 14, 2008; Bradford DeLong, “I Accept Larry White’s Correction.…” Cato Unbound, December 11, 2008; John Quiggin, “Austrian Business Cycle Theory,” Commentary on Australian & World Events from a Social Democratic Perspective, May 3, 2009; Bryan Caplan, “What’s Wrong with Austrian Business Cycle Theory?” EconLog, January 2, 2008.
Their basic point is that if investment goes up in the boom, consumption should go down; and during the bust when investment goes down, consumption will ipso facto go up. They conclude consumption did not go up in the bust — it went down significantly — and therefore ABCT has been disproven by the facts.
Instead of ABCT, what the critics are arguing against is a simple mainstream two-sector overinvestment theory of the business cycle. However, Austrian economists do not embrace an overinvestment theory, but rather a malinvestment theory. During the boom consumption does not go down but goes up for two reasons. First, the lower interest rate discourages savings and encourages consumption, and second, and more importantly, the wealth effect or net-worth effect of higher wages, asset prices, stock prices, and real estate prices encourages people to consume more. Consumers draw down their illusionary wealth because on paper they can afford it.
With people drawing down their true wealth they will actually be consuming their savings and wealth, and this implies that there will likely be less overall investment, not more, during the boom. During the bust phase, consumption will be relatively strong compared to capital investment, but because of unemployment, lower wages, a negative wealth effect and a general malaise among entrepreneurs, there will hardly be a boom in consumption. The fact that some mainstream economists would base their criticisms on an obscure and flawed presentation of ABCT could be an indication of malicious intentions. Salerno gave an in-depth analysis of this criticism of ABCT.Joseph T. Salerno, “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Quarterly Journal of Austrian Economics 15, no. 1 (Spring 2012): 3–44.
The Rational-Expectations Critique — Why Can’t Entrepreneurs Learn? ABCT has been criticized on the basis of rational-expectations theory. The critics argue that rational entrepreneurs could not be continuously fooled by artificially low interest rates. Based on entrepreneurs’ past experience and analysis of current market conditions, the critics ask, why would they be systematically fooled by the central bank?This criticism has already been addressed by several economists, such as Lucas Engelhardt, “Expansionary Monetary Policy and Decreasing Entrepreneurial Quality,” Quarterly Journal of Austrian Economics 15 no. 2 (Summer 2012): 172–94; Anthony J. Evans and Toby Baxendale, “Austrian Business Cycle Theory in Light of Rational Expectations: The Role of Heterogeneity, the Monetary Footprint, and Adverse Selection in Monetary Expansion,” Quarterly Journal of Austrian Economics 11, no. 2: 81–93 (2008); William Barnett II, and Walter Block, “Professor Tullock on Austrian Business Cycle Theory,” Advances in Austrian Economics 8 (2005): 431–43; and Anthony M. Carilli, and Gregory M. Dempster, “Expectations in Austrian Business Cycle Theory: An Application of the Prisoner’s Dilemma,” Review of Austrian Economics 14, no. 4 (2001): 319–30. For a review of these arguments, see Nicolás Cachanosky, “Expectation in Austrian Business Cycle Theory: Market Share Matters,” Review of Austrian Economics 28, no. 2 (2015): 151–65.
As I have emphasized throughout this book, the distortions in credit markets from artificially low interest rates are not something that is obvious to the casual observer, and the amount of distortion between the market rate and the natural rate is not known definitively by anyone. What we do know is that when you leave your ivory tower and investigate the economy, you will find that some entrepreneurs, bankers, and market analysts have the experience to detect the possibilities of such market distortions.
These people could act more cautiously, withdraw from certain markets, or require greater risk premia in their dealings. The problem for these people is that their competitors are acting in a boom market where everyone is seemingly making large profits and capital gains. Either you join the party or you get replaced. I have seen this displacement effect in the construction industry, banking, and even on CNBC.
ABCT shows that as the amount of loanable funds expands, less creditworthy borrowers will enter the market. Several economists have explored this adverse-selection argument at length.Evans and Baxendale, “Austrian Business Cycle Theory in Light of Rational Expectations”; and Engelhardt, “Expansionary Monetary Policy and Decreasing Entrepreneurial Quality.” Austrians see entrepreneurs as rational, but they also realize that the success or failure of a venture is dependent on many factors that cannot be known in advance. Easy-credit policies let more entrepreneurs into the process, the results of which are known not instantaneously, but only as or shortly after these long-term capital projects near or reach completion.
What about Nineteenth-Century Panics? ABCT has also been criticized for blaming the business cycle on the Federal Reserve when in fact there were business cycles in the nineteenth century before the Fed existed. I have already addressed this criticism in chapter 2 on the history of the skyscraper curse. ABCT actually blames the central bank and the fractional-reserve banking system. Even mainstream economists agree that the panics from the time of the Civil War to the time of World War I were caused by the National Banking Acts. The acts’ requirements ensured that bank deposits were structured in an unstable manner. Many also agree that business cycles prior to the Civil War were caused by the First and Second Banks of the United States, which were pseudo central banks.
What about Robert Murphy’s Prediction of Double-Digit Inflation? Critics of the Austrian school of economics have been throwing barbs at Austrians such as Robert Murphy because there is very little inflation in the economy. Of course, these critics are speaking about the mainstream concept of the price level as measured by the Consumer Price Index (CPI).
Let us ignore the problems with the concept of the price level and all the technical problems with the CPI. Let us further ignore the fact that this has little to do with Austrian business cycle theory, despite what the critics would like to suggest. The basic notion that more money (i.e., inflation) causes higher prices (i.e., price inflation) is not a uniquely Austrian view. It is a very old and commonly held view by professional economists and is presented in nearly every textbook that I have examined.
This common view is often labeled the quantity theory of money. Only economists with a mercantilist or Keynesian ideology even challenge this view. However, only Austrians can explain the current puzzle: why hasn’t the massive money printing by the central banks of the world resulted in higher prices?
Austrian economists such as Ludwig von Mises, Benjamin Anderson, and F. A. Hayek saw that commodity prices were stable in the 1920s but that other prices in the structure of production indicated problems related to the monetary policy of the Federal Reserve. Mises, in particular, warned that Fisher’s “stable dollar” policy, employed at the Fed, was going to have severe ramifications. Absent the Fed’s easy-money policies of the Roaring Twenties, prices would have likely fallen throughout that decade.
So let’s look at the prices that most economists ignore and see what we find. There are some obvious prices to look at, such as the price of oil. Mainstream economists really do not like looking at oil prices: they want them taken out of the CPI along with food prices, and Ben Bernanke says that oil prices have nothing to do with monetary policy and that oil prices are governed by other factors.
As an Austrian economist, I speculate that in a free market economy, with no central bank, the price of oil would be stable. I further speculate that in the actual economy with a central bank, the price of oil would be unstable and oil prices would reflect monetary policy in a manner informed by ABCT.
That is, artificially low interest rates generated by the Fed would encourage entrepreneurs to start new investment projects. This in turn would stimulate the demand for oil (where supply is relatively inelastic in the short run), leading to higher oil prices. As these entrepreneurs would have to pay higher prices for oil, gasoline, and energy (and many other inputs) and as their customers would cut back on demand for the entrepreneurs’ goods (in order to pay higher gasoline prices), some of the entrepreneurs’ new investment projects would turn from profitable to unprofitable. Therefore, you should see oil prices rise in a boom and fall during a bust. That is pretty much how things work.
As you can see, the price of oil was very stable when we were on the pseudo gold standard. The data also show dramatic instability during the fiat paper-dollar standard (post-1971). Furthermore, in general, the price of oil moves roughly as Austrians would suggest, although monetary policy is not the sole determinant of oil prices and obviously there is no stable numerical relationship between the two variables.
Another commodity that is noteworthy for its high price is gold. The price of gold also rises in the boom, and falls during the bust. However, since the last recession officially ended in 2009, the price of gold actually doubled. The Fed’s zero interest rate policy has made the opportunity cost of gold extraordinarily low. The Fed’s massive monetary pumping created an enormous spike in the price of gold. No surprise here.
Actually, commodity prices increased across the board. The Producer Price Index for commodities shows a similar pattern to oil and gold. The PPI (Producer Price Index) commodity index was more stable during the pseudo gold standard, with more volatility during the post-1971 fiat-paper standard. The index tends to spike before a recession and then recede during and after the recession.
High prices seem to be the norm. The US stock and bond markets are at, or near, all-time highs. Agricultural land in the United States reached an all-time high. The contemporary-art market in New York is booming, with record sales and high prices. The real estate markets in Manhattan and Washington, DC, are both at all-time highs as the Austrians would predict. That is, after all, where the money is being created, and the place where much of it is injected into the economy.
This doesn’t even consider what prices would be like if the Fed and world central banks had not acted as they did. Housing prices would be lower, commodity prices would be lower, and the CPI and PPI would be running negative. Low-income families would have seen a surge in their standard of living. Savers would get a decent return on their savings.
Of course, the stock market and the bond market would have seen significantly lower prices. Bank stocks would have collapsed, and the bad banks would have closed. Finance, hedge funds, and investment banks would have collapsed. Manhattan real estate would be in the tank. The market for fund managers, hedge fund operators, and bankers would have evaporated.
In other words, what the Fed chose to do ended up making the rich richer and the poor poorer. If it had not embarked on the most extreme and unorthodox monetary policy in memory, the poor would have experienced a relative rise in their standard of living and the rich would have experienced a collective relative decrease in their standard of living.
There are other major reasons why consumer prices have not risen in tandem with the money supply in the dramatic fashion of oil, gold, stocks, and bonds. It would seem that the inflationary and Keynesian policies followed by the United States, Europe, China, and Japan resulted in an economic and financial environment where bankers were afraid to lend, entrepreneurs were afraid to invest, and everyone is afraid of the currencies they are forced to endure.
In other words, the reason why consumer price-inflation predictions failed to materialize is that Keynesian policy prescriptions such as bailouts, stimulus packages, and massive monetary inflation have failed to work and have indeed helped wreck the economy.
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Economists understand very little about how technological progress occurs. — Alan Greenspan, “Testimony of Chairman Alan Greenspan”
Before we leave the topic of the problems and blessings of roundaboutness of production and the structure of production, it will be very useful to see a natural, concrete example of it in action. It then will become easier to understand the unnatural cases involving malinvestments and the skyscraper curse.
Making production processes more roundabout results in greater production in terms of the quantity produced and a lower cost on a per-unit basis. Entrepreneurs would not want to make production processes more roundabout unless they thought they would create more profits as a result. More roundabout production takes more time, more steps, and a more extensive division of labor. It also uses new technology.
Entrepreneurs do make mistakes, of course, but the only systematic errors they make are when they are fooled into rearranging production because of artificially low interest rates and easy credit conditions. When the central bank lowers its target interest rates it also makes credit conditions easier in that banks will make a larger volume of loans, which means they weaken their lending standards in order to facilitate the larger volume of loans.
A good example of a very direct production process, in contrast to a more roundabout one, is a farmer who goes to the barn, milks a cow, and then returns to the house and feeds the milk to his family.
An example of a more roundabout, although still very direct, production process comes from my childhood. We lived on the edge of a small town. Just beyond our house were fields and barns. Dairy cattle would feed on the grass in the fields. Later they would return to the barns to be milked. The milk would then be transported a short distance — a couple miles — in a small tanker truck to one of three small dairies in my hometown. There the milk would be processed and packaged. Early the next morning a dairy man in a white suit would arrive at our house and place several quart-size glass bottles of milk in an insulated dairy box outside of our back door and pick up any empty bottles we had placed there. If we wanted an ice cream sundae, we had to go to the dairy during retail hours.
By the time I graduated from high school the entire system had changed. The small dairy farms had been largely replaced with larger farms. The small four-wheel tanker trucks had been replaced by large eighteen-wheel tankers. An eighteen-wheel tanker truck brought the raw milk from the farms to the dairy factory about thirty miles from our house, and a different eighteen-wheel refrigerated truck brought cartons of milk and ice cream as well as boxes of butter to the supermarket. All three of the small hometown dairies eventually went out of business. They were replaced by much larger, factory-size dairies many miles from our home. Instead of having the milk bottles delivered directly to our house, we now purchased dairy products at the local supermarket, an institution that was also a relatively new phenomenon.
The dairy factory system is a much more roundabout production process. It takes more time. The milk travels a round-trip journey of more than sixty miles instead of the less-than-four-mile journey in the old days. There is a greater amount of capital as well as advanced technology involved and there is also far less labor per unit of milk. The overall cost of milk is lower, and with competition between large dairy wholesalers and supermarkets, so is the price.
In order to attain a more roundabout production process there are several requirements. It requires entrepreneurs with a vision of the most profitable action among all possible actions. It requires investment in more capital goods and new technology. Of course, all of this rearranging of production is going to take a great deal of time and even more time for it to be profitable.
Therefore, the entrepreneurs need to have access to savings. They need to have either their own savings or someone else’s savings on a long-term basis in order to proceed. Hence there must be more overall savings in an economy in order to achieve more roundabout production and all the benefits it entails. Savers must have lower time preferences and be willing to delay some consumption in the present. Savers will be rewarded with interest income, with which they will be able to make a greater number of purchases in the future and at lower prices because of the increase in production of goods. The whole process is regulated by the rate of interest, the price system, and the system of profit and loss.
This process is sometimes referred to as creating economies of scale. But notice that while there are economies of scale in this example, everything about the production process changed. The most successful approach was not preordained or known in times past. The entire recipe or technology of production has changed. All the capital goods — including the milking machines, the trucks, and the machinery inside the dairies — are different. Notice further that the change in the dairy industry is going to induce changes in other industries, including technology and investment in the mechanical milking machines industry. All of this requires a careful synchronization process, which is obviously beyond the scope of central planning. The process is driven by the rate of interest. So we will now see what happens when the interest rate is misleading and results in an economic bust and, in severe cases, the skyscraper curse.
In the wake of the financial crisis of 2008, the economics profession suffered a blow to what reputation it had. But unlike most of his colleagues, Mark Thornton was vindicated by 2008. Mark has been a voice of sanity at times when the wild interventions of the Federal Reserve have caused otherwise sensible people to lose their minds.
One rule of thumb I’ve adopted is: whenever the idea that the business cycle may have been tamed forever starts to become mainstream, the bust is around the corner.
After reading this book, you’ll see why. Mark discusses the very different records of Irving Fisher and Ludwig von Mises in the 1920s, with the former saying (in late 1929!) that stock prices had reached a “permanently high plateau” and Mises warning that all the artificial credit creation of the world’s central banks meant a reckoning was coming.
At the end of the 1960s, presidential economic adviser Arthur Okun announced that wise fiscal and monetary policy was making boom and bust a thing of the past. One month after his book on the subject was released, the United States was officially in recession.
The dot-com bubble of the 1990s continued the pattern. Federal Reserve chairman Alan Greenspan even speculated that we had entered an age in which booms no longer necessarily had to be followed by busts.
I trust you know what happened next.
The most recent financial crisis, which was connected to an especially destructive housing bubble, yielded the same kind of crazy commentary: why, real estate prices never fall!I trust you know what happened next.
In fact, Mark Thornton was one of a handful of economists to warn — as early as 2004 — of a housing bubble and its inevitable consequence. That was a lonely position to adopt in those days. Nobody wanted to hear the words “unsustainable” or “bubble” when buying multiple properties and sitting on them seemed to be a path to certain riches. Of course, Mark was the voice that would have done them the most good had they bothered to listen, because they might thereby have limited their exposure to the bust that was surely coming.
But when all so-called respectable voices are assuring everyone that all is well, it is the wise man who appears to be the crank.
Now had Mark been known for nothing more than being a conscientious historian of these earlier business cycles and an accurate prognosticator of the housing bust and financial crisis, that would be ample reason to respect him as a scholar worthy of our attention and respect.
But of course Mark has done much more than this. In this book, for instance, you will encounter Mark’s work on the so-called “skyscraper curse.” I shall not here disclose Mark’s thesis on the matter; the author of a foreword ought to know his place, and stealing the author’s thunder is rather unbecoming.
For now, I can say this: although a correlation between the setting of new skyscraper records on the one hand and plunges into recession on the other had been noted by certain writers, the connection had been generally dismissed as little more than a curious coincidence. Mark, on the other hand, has shown how the two phenomena are connected — not that tall skyscrapers cause the business cycle, of course, but rather that they embody numerous features of the boom period described by Austrian business cycle theory.
Austrian business cycle theory, in turn, is probably the most important piece of economic information and understanding for Americans and indeed the world to understand right now. Again I shall leave the full exposition to Mark. For now, what matters is that according to economists of the Austrian school, the familiar pattern of economic boom and bust is not an inherent feature of the market economy, but instead the product of intervention into the economy by the monetary authority. When the central bank lowers interest rates below what they would have reached on the market, it sets in motion a series of responses by investors and consumers that will prove to be incompatible. The result is the recession, which is the economy’s return to health: the economy’s unsustainable configuration is unwound, and resources (including labor) are reallocated to lines of production that make sense in terms of resource availability and consumer preferences.
In the pages that follow, Mark explains the theory, applies it to various historical (and present) cases, and rebuts the most common objections.
In short, this collection serves the valuable purpose of defending the market economy against the conventional view that freedom has failed us and we need still more controls. We had plenty of rules and bureaucrats on the eve of the financial crisis. A lot of good that did us. Pretty much none of them saw any problems on the horizon, and the sheafs of rules and regulations were aimed in the wrong direction: while the private sector operated in the equivalent of a Kafka novel, the Federal Reserve was able to carry out its mischief unimpeded.
Here’s a crazy thought: maybe this time we might consider a real free market, with sound money and market interest rates, and abolish the giant bubble machine once and for all. Read Mark Thornton and you’ll entertain this and other forbidden thoughts.
Thomas E. Woods, Jr.Harmony, Florida
As of November 2013, it was official. New York City had won the title of having the nation’s tallest structure. The heated controversy between New York and Chicago was settled when the Council of Tall Buildings and Urban Habitat, based in Chicago, decided that the 408-foot spire sitting atop One World Trade Center could be included in the total height of the building.
The revised height of 1,776 feet made One World Trade Center the tallest structure in the United States. We are told that One WTC is more than a building. It both serves as a monument to those murdered on 9/11 and honors our Declaration of Independence. Not to disrespect those who died, but this “record” is a sham because the useable, productive height of the building is only 1,368 feet. The remaining 400-odd foot difference is just uninhabitable window dressing.
This dubious record should nonetheless be a kind of warning to us that the skyscraper curse, the forerunner of economic crisis, is lurking near.
The Shard Building, in London, broke ground in 2009 and was completed in 2012, becoming the tallest building in Europe. This was a clear signal of the European economic crisis, the PIIIGS fiscal disaster — in Portugal, Italy, Ireland, Iceland, Greece, and Spain — and the grave and ongoing concerns over the long run viability of the euro. Japan joined the fraternity with the Tokyo Skytree broadcasting tower, which was completed in 2012 and is now the tallest structure in Japan. Not to be outdone, China set a new national skyscraper record with the Shanghai Tower, which opened in 2014. China also broke ground but suspended construction on Sky City tower in part because of fear of the skyscraper curse. It too would have set a new world record.
World-record-breaking skyscrapers are a signal of economic crisis. Like world-record-breaking art prices, such as the $142 million selling price of a painting by Francis Bacon of his friend Lucian Freud at Christie’s in New York in 2013, such records are signs of economic excess. Just remember that such excess usually occurs in markets manipulated by central banks.
These are the spectacular results associated with the skyscraper curse, but you also might be able to see signs of it at work in small-town America. For example, there are no true skyscrapers being built in Auburn, Alabama, home of Auburn University and the Mises Institute. But there has been a great deal of building big and tall for this small city in eastern Alabama.
Luxury student-apartment building leads the way, followed by high-end restaurants and retail space. Recently two student-apartment buildings were torn down to make room for yet bigger buildings. The city government is also spending truckloads of money on street improvements and a state-of-the-art high school. More recently, old single-floor buildings have been demolished downtown to make room for multistory high density apartments.
What are people thinking? Don’t they realize we are in one of the weakest recoveries on record and headed for another recession? Has no one in Auburn realized there is an enormous amount of student debt and that the job market for holders of college degrees is weak? Is it greedy bankers and construction companies run amuck? Is it out-of-control architects and chefs that are to blame? Or is it the spoiled rich college kids who demand luxury apartments and locally grown veggies at the high-end restaurants they frequent?
The rush to build bigger, taller, and more luxurious buildings actually has little to do with any of these groups, but it has divided us as a city. On the one hand, there are many people upset because all this construction is changing “the loveliest village on the plains.” Local residents are seeing “Keep Auburn Lovely: Save Our Village” signs popping up all over town. They oppose the building spree.
On the other hand, construction workers, cement dealers, building-supply companies, and heavy-equipment operators must love the fast-paced business and full-time jobs with overtime. They love it while heavy dump trucks and cement trucks rush their loads through town.
The problem actually starts in Washington, DC, in an unremarkable building at Twentieth Street and Constitution Avenue NW that houses the Board of Governors of the Federal Reserve. The board, along with the president of the New York Fed, and a rotating selection of regional Federal Reserve Bank presidents, forms the Fed’s Open Market Committee (FOMC), which sets the policy targeting the interest rate that banks charge other banks for very short-term loans — the federal funds rate.
When the Federal Reserve’s Open Market Committee sets the target lower, it sets off a tendency for interest rates to fall across the economy. When it raises the target for the federal funds rate, interest rates tend to rise across the economy. For the last seven and a half plus years they have kept the target under a quarter of 1 percent. This type of policy has never been pursued before. This explains the ultralow rates on your savings account and home mortgage over the last several years.
It also explains the luxury-building mania. When the Federal Reserve first lowered rates, bankers who were burned by bad mortgages after the collapse of the housing bubble, along with luxury game-day condo builders, would not take the bait. Once bitten, twice shy. However, eventually low interest rates become too tempting to resist, especially as new bankers and construction companies come onto the scene.
Lower rates have several effects, including less saving and more spending. Low rates also increase stock market prices because lower rates increase the value of corporations, reduce the cost of borrowing, and induce individuals to move money from bank accounts to stock market accounts and to be more fully invested in stocks. When the policy is successful at increasing stock prices, people reduce savings further and spend more on luxury goods. Lower rates also boost borrowing and investment.
If you think that the combination of reduced savings and increased luxury spending sounds contradictory and dangerous, you are correct.
In any case, lower interest rates also tend to increase the price of land, particularly in the central business district. In contrast, higher interest rates encourage land and real estate owners to part with their properties at lower prices. Higher land prices make development deals harder to generate profits. The solution is to build more intensively and to make buildings taller. A $1 million piece of land could be made profitable by building just one story, but if that same lot is $2 million then you might have to build three stories to make it profitable. A one-story building is relatively inexpensive to build compared to a three-story building, which requires stairways, elevators, and sturdier construction techniques. However, the three-story building also produces two and a half times more rentable space.
Is it better to just build something, even if it is the wrong something? Well, even if interest rates could stay near zero forever, it would still mean we are deploying our resources incorrectly. The things we are building will not be as profitable as originally projected, and the excess capacity means that long-existing projects will also become less profitable. In other words, eventually, their economic values will be less than the amount invested in them. It will also make it more difficult to pay back the loans, especially if you reduce savings and increase your borrowing and luxury spending.
These circumstances are in no one’s long-term best interest. But apparently, eliminating the cause in Washington is currently beyond our collective ability.
In 2014, there should have been a skyscraper alert issued for China. Groundbreaking ceremonies took place on what was expected to be the world’s tallest skyscraper, called Sky City tower. This project was noteworthy not just as an attempt to build a record-breaking skyscraper of 2,749 feet in height, but also because of the remarkably short construction schedule due to the construction company’s prefabricated construction process. Initially, on-site construction was delayed until April 2014. Later, the government cancelled the project due to environmental concerns over nearby wetlands. That reversed the need to broadcast a skyscraper alert.
The confluence of regional skyscraper signals in Europe, North America, and China, along with a skyscraper alert clearly suggested the possibility of a burgeoning world-wide economic crisis. This pattern would be very much like previous episodes of skyscraper records including the panic of 1907, the Great Depression, the stagflation of the 1970s, the Asian contagion ∕ dot-com bubble, and the housing bubble. In line with these skyscraper-based predictions, a fundamental case can be built around the notion of a looming world economic crisis. Most of the world’s major economies are facing pressing economic difficulties, including the United States, Europe, Russia, Brazil, Japan, and China. Additionally, central banks have been engaged in a worldwide currency war since the housing bubble, on a scale that has never been experienced in human history. It should not be surprising that super tall buildings are being built at an astonishing rate.
Not only is the world teeming with real estate speculation and skyscraper-building from China, to New York, to London and the Middle East, there is a new world-record-setting skyscraper being constructed in Jeddah, Saudi Arabia. The Kingdom Tower is designed to be over one kilometer in height, or more than eleven football fields. It is scheduled to be completed in 2020. As designed, the Kingdom Tower will exceed the height of the Burj Khalifa by more than 500 feet, although only a few floors of inhabitable space. If events proceed as the skyscraper curse predicts, the beginning of construction of the Kingdom Tower signaled a crisis alert, as a new record-breaking skyscraper has had its groundbreaking ceremony. This will change to a skyscraper signal when a new record height has been achieved between now and 2020.
The skyscrapers can sometimes tell us about the geography of world economic bubbles. The last bubble occurred in the oil-rich Middle East, and the next one would also be in the Middle East. Both bubble projects were begun when oil prices exceeded $100 a barrel.
It is interesting to note that according to Television Post,Television Post, “Prince Alwaleed Sells 5.6% Stake in News Corp for $188 Million,” March 2, 2015. Prince Alwaleed, the owner of the Kingdom Tower project, recently and unexpectedly sold most of his large stake of stock in News Corp., Rupert Murdoch’s media conglomerate, to raise nearly $200 million. The move was said to have been part of an overall review and rebalancing of the prince’s $20 billion portfolio. This is probably a smart move given the collapse of oil prices and the hefty price tag of $1.2 billion for the prince’s Kingdom Tower.
With more financing in place, the next world’s tallest skyscraper project is moving forward. The final piece of financing that is necessary to bring the $1.2 billion Kingdom Tower project in Saudi Arabia to record heights has been obtained. Media reports also show that the structure has risen to more than seventy-five meters (246 feet), and construction is proceeding at an uninterrupted pace, although there remain many concerns about the project’s viability. (Subsequently, the project experienced more delays.)
For example, above-ground construction on the long-delayed Kingdom Tower, now called the Jeddah Tower, started in September 2014, but there was considerable doubt that the financing for the one-kilometer (3,280.84 feet) tower could be obtained, given the shaky financial conditions in Saudi Arabia.
But the Jeddah Tower is only the latest phase in an enormous boom that began setting new records in 2014. As I reported in February 2015:
Super tall buildings, or skyscrapers, are being built at an astonishing rate. Ninety-seven buildings that exceed 200 meters (656 feet) high were constructed in 2014, setting a new record. The previous record was eighty-one buildings completed in 2011. The total number of skyscrapers in existence now is 935, a whopping 350 percent increase since the year 2000.Mark Thornton, “Where Is the Skyscraper Curse Today,” Mises Daily, February 24, 2015.
If completed as planned, Jeddah Tower will be the tallest building in the world. Jackie Salo, in the International Business Times, reports:
Saudi Arabia’s Kingdom Tower in Jeddah is slated to become the world’s highest skyscraper when it is erected in 2020, knocking Dubai’s Burj Khalifa tower from its perch as tallest building at 2,716 feet. The new tower will claim the title if it reaches its planned height of 3,280 feet. …The 200-floor Kingdom Tower will be part of a reported $8.4 billion project to construct Jeddah City. Construction of the skyscraper will entail 5.7 million square feet of concrete and 80,000 tons of steel.Jackie Salo, “World’s Tallest Skyscraper Is Saudi Arabia’s Kingdom Tower? Jeddah Building Projected to Break Height Records,” International Business Times, December 1, 2015.
In other words, the Tower could be the next record-breaking skyscraper, which is just part of an even more massive project. That means it’s time for a new skyscraper alert (as of January 1, 2016).
Remember, a skyscraper alert is an indicator that suggests a significant economic crisis will occur in the near future, even though economic conditions currently appear good. This alert could have been issued earlier, because an alert is defined based on the groundbreaking ceremonies of a world-record-breaking skyscraper, not the initial announcement of the project, which in this case occurred in August 2011. At that time there was still considerable doubt the project would be completed as planned.
Skyscraper alerts indicate significant looming danger in the economy, but the danger is not necessarily imminent. The next pivotal date for the Jeddah Tower project is when it reaches the height to break the old record and a skyscraper signal is given. That date is difficult to estimate given the uncertainty of construction. Media reports indicate that the project will be completed in 2020 without indicating whether that date is the completion date or the opening ceremonies.
So, will this latest frenzy of new construction tip us off to the next bust? The Skyscraper Index is silent on the issue of timing, so the dating of when the skyscraper curse becomes apparent is just guesswork. It seems that the boom reaches its peak around the time the new record height is set, and this is when a skyscraper signal should be issued. The skyscraper signal means that economic danger is looming. In most episodes, record-breaking skyscrapers generally have their completion dates and opening ceremonies when the economic crisis is readily apparent.
The important thing to remember is that skyscrapers do not cause economic crises. Rather they are just very noticeable examples of the distortions taking place throughout the economy when interest rates are kept artificially low by the central bank. This point will be thoroughly reinforced in the next chapter.
Razorbacks are wild pigs that are bulky, strong, fast, and ferocious. They inhabit a very large range in large numbers and are omnivorous and highly adaptable. Wolverines are the largest species of weasel, about the size of a small bear. This fast, muscular carnivore has a well-deserved reputation for strength and ferocity. Do these creatures have anything to do with the skyscraper curse?
No, they don’t, but they did inspire an important article by Greg Kaza.
When I give public lectures on the skyscraper curse, I am inevitably asked whether it can be applied on continental, national, and state levels, rather than just a global scale. For example, would a national-record-breaking skyscraper result in a national curse? My answer to those questions is yes, but that is only based on anecdotal evidence.
Greg KazaGreg Kaza, “Note: Wolverines, Razorbacks, and Skyscrapers,” Quarterly Journal of Austrian Economics 13, no. 4 (Winter 2010): 74–79. examined the Skyscraper Index evidence at the state level in the United States. He chose the states of Arkansas and Michigan. Greg is from Michigan and earned his master’s degree in international finance from Walsh College, in Michigan. He has served as executive director of the Arkansas Policy Foundation since 2001. The team names for the University of Arkansas and the University of Michigan are respectively the Razorbacks and Wolverines.
He used the National Bureau of Economic Research’s (NBER) estimates of economic expansions and contractions in the US economy. He compared that data with data on the tallest buildings in both states. What he found was confirmation of the Skyscraper Index at the state level. According to Kaza:
Michigan’s tallest skyscrapers in the early 20th century, Detroit’s Dime Building and Penobscot Annex, were completed in 1913, a recession year. Detroit’s Guardian and Penobscot buildings were finished in 1928–29 on the Great Depression’s eve. Today, Michigan’s tallest building is the Detroit Marriott at the Renaissance Center, completed in an expansion (1977). Its final tower, however, was finished in the July 1981–November 1982 contraction.Ibid., p. 76.
So the experience in Michigan would seem to confirm the Skyscraper Index. It should also be pointed out that with regard to the Detroit Marriott, the American automobile industry, centered in Detroit, Michigan, was still a vital force relative to the rest of the economy in the 1970s, although that would soon change.
The results were similar in the state of Arkansas. The state is largely an agricultural economy, although that has changed some with the rise of Wal-Mart, which has its headquarters in Bentonville, Arkansas. According to Kaza the state followed the familiar pattern:
A similar effect can be observed in Arkansas. Little Rock’s Pyramid Life Building (1907), Union Life Building (1913), Donaghey Building 2 (1926), Tower Building (1960), Bank of America Building (1970) and Region’s Bank Building (1975) were all completed around NBER contractions. The lone exception, Metropolitan Tower (formerly the TCBY Building) was completed in 1986, a year of expansion.Ibid., pp. 76–77.
The Metropolitan Tower might have been completed during a national expansion of the economy, but such was not the case in Arkansas. As the building was being built, the state of Arkansas was entering a very strong economic contraction. According to Henderson, Gloy, and Boehlje:
U.S. agriculture could not sustain the 1970s prosperity and, similar to the 1920s, U.S. export activity collapsed during the 1980s. After peaking at $96 billion in 1980, real U.S. agricultural exports fell sharply. A weak global economy, world debt problems, a strong exchange value of the dollar and trade barriers — including a Russian grain embargo — cut U.S. agricultural exports (Drabenstott 1983). In 1986, agricultural exports bottomed at $47 billion, half the levels posted five years earlier.Jason Henderson, Brent Gloy, and Michael Boehlje, “Agriculture’s Boom-Bust Cycles: Is This Time Different?” Economic Review (4th quart. 2001): 88.
So the lone failures of the Skyscraper Index in Arkansas and Michigan are really about the difficulties that can arise using national statistics on state-level phenomena.
Kaza raises two other important points. The first point is that the tallest buildings in twenty states were completed in years of NBER contractions. It might be interesting to examine the other thirty buildings to see whether their record-breaking dates, in contrast to completion dates, might have occurred during an economic expansion. The second point is that he found, using NBER dating, that the Woolworth Building, which opened in April 1913, did so in a twenty-three-month-long contraction in the US economy between January 1913 and December 1914. This was a long and severe contraction. However, it was not long enough or deep enough to gain a moniker achieved by other skyscraper-cursed buildings.
While Lucas EngelhardtLucas Engelhardt, “Why Skyscrapers? A Spatial Economic Approach.” Unpublished manuscript, 2015. shows that the skyscraper-curse analysis can be integrated into the microeconomic analysis of labor markets and location theory, KazaKaza, “Note: Wolverines, Razorbacks, and Skyscrapers.” has shown that it can also be situated into lower levels of geographic analysis.
The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Century By Mark Thornton
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In 1993, Milton Friedman proposed his famous “plucking model”Milton Friedman, “The ‘Plucking Model’ of Business Cycle Fluctuations Revisited,” Economic Inquiry 31, no. 2 (1993): 171–77. of the business cycle. To understand this theory, imagine a string or straight rising line on a graph that represents the potential growth of the economy. Also on the graph is another string that represents actual economic growth and follows the potential growth line except for when the second string is “plucked” downward by policy mistakes or external forces. In Friedman’s model, after the economy has been plucked economic growth quickly returns to the potential growth string. For Friedman it is important to explain the pluck and economic bust, but not the boom because in his model the boom is normal.
Friedman would recommend no special polices regarding the business cycle other than avoiding policy errors. If monetary policy is too tight, loosen it. In particular, money mattered for Friedman and the monetarists, and Friedman argued that a mistakenly restrictive monetary policy and high real interest rates were responsible for the Great Depression. GarrisonRoger Garrison, “Friedman’s ‘Plucking Model’: Comment,” Economic Inquiry 34, no. 4 (1996): 799–802. provides an effective critique of the plucking model.
In the Friedman context, you could try to make an argument that policy makers made an error that brought on the financial crisis, but this would conflict with Friedman’sMilton Friedman, Interview on Charlie Rose, December 29, 2005. own vision. He appeared on the Charlie Rose show on December 29, 2005, the zenith of the housing bubble, and summarized his view of the US economy: “The stability of the economy is greater than it has ever been in our history. We really are in remarkably good shape. It’s amazing.”
He went on to praise Alan Greenspan and the work being done at the Federal Reserve. Not only did Friedman fail to see the housing bubble, but his recommended policy response of loosening the supply of money and credit did not solve the problem. In fact, a loose monetary policy of zero interest rate policy (i.e., ZIRP) and quantitative easing (i.e., QE), have all failed to get the economic-growth string back to the potential-economic-growth string thus far.Ryan Murphy, “The Plucking Model, the Great Recession, and Austrian Business Cycle Theory,” Quarterly Journal of Austrian Economics 18, no. 1 (Spring 2015): 40–44.
Another string theorist is Ben Bernanke. The former chairman of the Fed was a student of the Great Depression and Friedman’s work on that subject. More generally he is considered to be in the camp of the New Keynesian school, which assumes that people have rational expectations about the future but live in an economy with imperfections and market failures. Extending Friedman’s work, Bernanke found in his research that the collapse of the banking sector in 1933 was the main reason that the depression was “great.” The stock market crash and ensuing economic crisis weakened banks, and many of them failed. After FDR’s bank holiday in March 1933 the normal channels of credit turned into a market failure that held back the economy for many years to come. The bank failures were like a weight hung on the actual-economic-growth string preventing it from reconnecting to the potential-economic-growth string. Therefore Bernanke places a great deal of emphasis on protecting the large, systemically important banks and the credit-industry infrastructure. However, he also believes that loose monetary and fiscal policies are necessary for controlling the business cycle.
On the occasion of Milton Friedman’s ninetieth birthday, Bernanke delivered extensive remarks on Friedman and Schwartz’sMilton Friedman, and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963). work on the Great Depression, holding it in the very highest regard. Although some of his conclusions do differ from Friedman and Schwartz, BernankeBen S. Bernanke, “Remarks by Governor Ben S. Bernanke,” Speech at the Conference to Honor Milton Friedman, University of Chicago, November 8, 2002. closed his remarks on the Great Depression with the following apology and promise: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression, you’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
Bernanke was working at the Fed as vice chairman and then chairman during the housing bubble. He repeatedly denied the existence of the housing bubble and often suggested that if a bubble did exist and did pop, he would just lower interest rates. When it became evident that there was trouble in the housing market Bernanke moved aggressively in terms of monetary policy. He used both policies along traditional lines, such as reducing the federal funds rate and the discount rate, and aggressive, untried nontraditional policies, such as quantitative easing and zero interest rate policy. The overall policy response included radical decreases in interest rates, radical increases of liquidity in banks, a bailout of the systemically important banks and industries, and an enormous fiscal stimulus from the federal government, including multiyear trillion-dollar deficit spending. Bernanke soon began speaking of his ability to see “green shoots” in the economy, but many years later the actual-economic-growth string continues to lag badly behind the potential-economic-growth string.
Paul Krugman will here represent the Keynesian school of economics. The Keynesian view of the business cycle is based on social psychology. In the Keynesian view, periods of investment euphoria give way to periods of panic, retrenchment, and depression. If the actual-economic-growth string veers even slightly down from the potential-economic-growth string, then this sets up a potential scenario of dashed expectations, cutbacks, and diminished investment that can lead to layoffs, high rates of unemployment, and a significant decline in aggregate demand. This scenario is caused by what Keynes himself referred to as “animal spirits,” which is the irrational fear associated with investment.
When aggregate demand does not keep up with aggregate supply, this leads to lower prices, or price deflation. This can plunge an economy into what Krugman describes as an economic “black hole” from which the economy will never recover. As such, Keynesian economists and mainstream economists more generally have a phobia of deflation, or “apoplithorismosphobia,” which is the irrational fear of price deflation. However, much has been written about why deflation is not to be feared.See Philipp Bagus, In Defense of Deflation (New York: Springer, 2015); Jörg Guido Hülsmann, Deflation and Liberty (Auburn, AL: Mises Institute, 2008); Greg Kaza, “Deflation and Economic Growth,” Quarterly Journal of Austrian Economics 9, no. 2 (Summer 2006): 95–97; Mark Thornton, “Apoplithorismosphobia,” Quarterly Journal of Austrian Economics 6, no. 4 (Winter 2003): 5–18; Joseph T. Salerno, “An Austrian Taxonomy of Deflation—with Applications to the U.S.” Quarterly Journal of Austrian Economics 6, no. 4 (Winter 2003): 81–109, and “Deflation and Depression: Where’s the Link?” Mises.org, August 6, 2004.
Krugman has been very vocal since the financial crisis, calling for aggressive fiscal stimulus — that is, for the government to borrow vast amounts of temporarily unused savings and spend it. What the government spends the money on is less important than how much it spends beyond its means. It is important that consumers get money in their pockets, that businesses are put back to work doing something, and that the spending has the biggest possible impact on increasing aggregate demand. Certain important industries should receive bailouts if necessary, and public works programs should be begun in hard-hit areas. In order to guard against the possibility of deflation Krugman also recommends a stimulative monetary policy. Krugman has even argued that a Martian invasion hoax would fix the economy:
If we discovered that space aliens were planning to attack and we needed a massive buildup to counter the space alien threat and really inflation and budget deficits (concerns) took secondary place to that, this slump would be over in 18 months. And then if we discovered, oops, we made a mistake, there aren’t any aliens, we’d be better off.Paul Krugman, “Krugman Calls for Space Aliens to Fix U.S. Economy?” Global Public Square, August 12. 2011.
Krugman even later congratulated Japan for adopting the “moral equivalent of space aliens” in the form of Abenomics (i.e., aggressive monetary and fiscal stimulus), and for rejecting the “austerian orthodoxy” (i.e., balanced budgets).
The problem for Krugman is that with the exception of the fake Martian invasion, all of these policies have been implemented in the United States at unprecedented levels since 2008. In Japan, they have been implemented at higher levels for a longer period of time, to no good effect. Of course Krugman might object that these policies were still not large enough or quick enough to solve the problem. However, that just means his approach is untenable: Keynesians cannot predict a crisis in advance, because their analysis of the economic crisis starts with an unpredictable shock to social psychology; similarly, in the case of RBCT (real business cycle theory), the analysis starts with an unpredictable technological shock, or some other exogenous change.
These theories of the business cycle start with stylized facts that describe business cycles. From this, economists develop a hypothesis concerning what causes the business cycle. From this hypothesis, they develop a policy recommendation that agrees with their ideological perspective. Conservative economists — for example, those of the Chicago school — typically recommend no or limited remedial policy actions when faced with an economic downturn, while liberal economists from Ivy League universities are much more likely to recommend significant government intervention when faced with the same crisis. The most general problem with these approaches is that all of these recommendations have been tried since the beginning of the financial crisis and they have all failed.
[The original version of this chapter was published as “Is the Housing Bubble Popping?” LewRockwell.com, August 8, 2005.]
Friday, August 5, 2005, was a bad day for housing stocks and this could be a sign that the housing bubble may have sprung its first leak. This is what the Philadelphia Stock Exchange Housing Sector Index looked like this week — losing about 5 percent for the week.
Investors have made around 50 percent on their money since I first reported on the housing bubble,Mark Thornton, “Housing: Too Good to Be True,” Mises Daily, June 4, 2004. and there could very well be more bubblingto come. In this graph of high-flying Toll Brothers (TOL), one of the largest home-building companies. The stock has increased by over 50 percent in the last year. Optimists point to the company’s price-to-earnings ratio of “only” fifteen, which is below the market average.
The pessimist’s case for a bursting or deflating of the housing bubble is the issue of rising interest rates. As Greenspan increases short-term interest rates it causes problems for those who have variable-rate mortgages tied to short-term interest rates. Energy prices and a slowdown in the economy can also dampen enthusiasm in the housing sector.
The larger problem may be for long-term rates because they are the foundation for fixed mortgage rates. As Greenspan increases short-term rates the thinking goes that he is reducing inflation expectations and thus reducing the likelihood of increases in long-term rates. However, if long-term rates rise, this is an indication that short-term rates are not rising fast enough to dampen inflationary price pressures.
Long-term interest rates are rising and there was a big increase in the interest rate on ten-year Treasury bonds on Friday, August 5th that coincided with the fall in home-builder stocks. Over the last summer this interest rate made a “double bottom” at about 3.9% which is almost the lowest it has been in my lifetime. It is now 4.4% and probably headed higher. [Note: it was 5.25% a year later.]
A double bottom is a term from technical stock analysis that is a bullish indicator, which in this case predicts higher long-term interest rates. Higher rates spell trouble for the home builders and give some indication the housing bubble might be coming to an end.
Hopefully, Alan Greenspan will know the correct lever to pull next. He did in the 1960s.Ron Paul, “Ron Paul vs. Alan Greenspan.” Testimony before the House Financial Affairs Committee, July 20, 2005.
Postscript If you look at a long-term chart of the Philadelphia Stock Exchange Housing Sector Index (symbol HGX) you will see that this was indeed the exact turning point for home-builder stocks, which typically lead the actual housing market. The Taylor rule, a guide to monetary policy, can also be said to have predicted the housing bubble ∕ financial crisis. WoodsThomas E. Woods, Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse (Washington, DC: Regnery Publishing, 2009). is the best analysis of the housing bubble, financial crisis, and the policy response to it.
Foreword by Thomas E. Woods, Jr.
Introduction
Section 1: The Skyscraper Curse
Chapter 1: What Is the Skyscraper Curse?
Chapter 2: The History of the Skyscraper Curse Reexamined
Chapter 3: Do You Have a Theory?
Chapter 4: How to Get Milk
Chapter 5: Cantillon Effects
Chapter 6: Cantillon Effects in Skyscrapers
Chapter 7: The Curse Misses New York. Is Auburn, Alabama, Next?
Chapter 8: When Will the Next Skyscraper Curse Come?
Chapter 9: It Is Not the Skyscraper’s Fault
Chapter 10: Should I Stay, or Should I Go?
Chapter 11: Razorbacks and Wolverines
Chapter 12: The Curse of the Federal Reserve
Section 2: And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years
Chapter 13: Who Predicted the Great Depression?
Chapter 14: The “New Economists” and the Depression of the 1970s
Chapter 15: The Return of the Austrians
Chapter 16: Bubble-Bust in Japan
Chapter 17: Who Predicted the Bubble? Who Predicted the Crash? Bubble Predictions Conclusions Appendix: Some Other Predictions
Chapter 18: “Bull” Market?
Chapter 19: Housing: Too Good To Be True More Greenspan The Housing Bubble Price Inflation Follows Monetary Inflation The Dirty Secret Do Housing Bubbles Burst?
Chapter 20: The Economics of Housing Bubbles What Causes Housing Bubbles? What Goes Up ... ... Must Come Down Summary and Conclusions Postscript — August 8, 2009
Chapter 21: Is the Housing Bubble Popping?
Chapter 22: Making Depressions Great Again
Chapter 23: String Theories
Chapter 24: What Is Wrong with ABCT? Criticisms of the Hydraulic Version of ABCT The Rational-Expectations Critique — Why Can’t Entrepreneurs Learn? What about Nineteenth-Century Panics? What about Robert Murphy’s Prediction of Double-Digit Inflation?
Chapter 25: Summary and Conclusion: End the Fed
Bibliography
Index
It was on a weekend during the winter of 2004 and I was getting suspicions of the coming of another Fed-induced bubble like the one of the late 1990s. Social psychology seemed to be becoming more optimistic. However, it was not perfectly clear if it was just a general boom throughout the economy, or a bubble in a particular sector. I decided to take a look for myself.
It would be hard to deny that the American stock exchanges are experiencing bull markets. Last year (2003) the NASDAQ was up over 50 percent while the Dow 30 and S&P 500 had gains of 25 percent, and it seems that everyone is bullish this year. The Dow Theory (which is not much of a theory) tells us that we are in a bull market. If you are a follower of the “January effect,” where the month of January somehow determines the fate of the market for the year, you should also have a bullish outlook because all the stock market indexes ended the month in positive territory.
Only the New England Patriots’ victory would seem to have spoiled the party. The Super Bowl indicator predicts a good year for the stock market if a team from the old NFC wins and a bad year when a team from the AFC wins. Then again the Super Bowl indicator has lost some of its magic in recent years. Maybe we should switch to political indicators, which would suggest big gains in stocks during an election year.
But is the stock market truly showing signs of prosperity, or is it just BS?
I would like to suggest the latter and that it might not be a good time for you to obtain a home-equity loan to invest in hot tech stocks. We are going through a housing bubble, and stock valuations as measured by stock price-to-earnings ratios are at bubble levels. The buy low, sell high philosophy would lead you to sell stocks now, not buy them.
I’m not suggesting that you sell your house or cash in your retirement funds, only that you don’t throw caution to the wind and abandon traditional guidelines. Over 90 percent of stocks are now trading above their two-hundred-day moving average. I usually think of selling stocks, or at least stop buying them, when this indicator approaches 80 percent and then throw the cash back into the market when it gets down to the 20–30 percent level. At a minimum, investors should take the time to evaluate their assets and portfolio allocations between stocks, bonds, cash, and gold — between speculation and safety.
What is the case for a BS stock market based on?
First, the Federal Reserve has pushed short-term interest rates down to historically low levels. This has certainly buoyed stock prices, but it also has stymied savings and encouraged increases in consumption and debt. Americans have low levels of savings and high levels of debt, and this is simply not good for the health of the economy. In fact, statistics indicate that Americans have been taking money out of saving accounts and putting it into the stock market, but are not increasing their overall savings.
Second, the federal government has increased spending and debt at a rapid rate. Both are bad for the health of the economy, but do serve to keep up the appearance of prosperity in economic statistics such as GDP and the unemployment rate. When economic recovery is fueled by government spending, combined with stimulated consumption spending and housing construction, how real can the prosperity be?
Looking backward, we should also remember the decrease in the value of the dollar. Thanks to the Federal Reserve, the US dollar index lost approximately 15 percent of its value in 2003. If you had parked your money in a foreign bank or foreign bonds you could have avoided the loss plus earned interest, making the 25 percent gains on US stocks hardly spectacular in comparison.
Looking forward, we should note that the percentage of investment advisors who are bullish on the market is near the highest level experienced over the last four years. The percentage of investment advisors who are bearish is near the lowest level over the same time period. This psychological indicator is a contrarian indicator in that the larger the number of bulls and the smaller the number of bears, the more likely is a “correction” in the stock market. It is not a perfect indicator — nothing is — but it does line up with economic analysis in finding some trouble ahead in the US stock market.
This takes me to my disclaimer. If investment advisors as a group tend to be wrong about the future of the stock market, then how good can my advice and analysis be? The answer is caveat emptor, and that’s no BS.
In the wake of the financial crisis of 2008, the economics profession suffered a blow to what reputation it had. But unlike most of his colleagues, Mark Thornton was vindicated by 2008. Mark has been a voice of sanity at times when the wild interventions of the Federal Reserve have caused otherwise sensible people to lose their minds.
This collection serves the valuable purpose of defending the market economy against the conventional view that freedom has failed us and we need still more controls. We had plenty of rules and bureaucrats on the eve of the financial crisis. A lot of good that did us. Pretty much none of them saw any problems on the horizon.
Maybe we should consider a real free market, with sound money and market interest rates, and abolish the giant bubble machine once and for all. Read Mark Thornton and you’ll entertain this and other forbidden thoughts.
From the Foreword by Thomas E. Woods, Jr.
The Skyscraper Index expresses the strange relationship between the building of the world’s tallest skyscraper and the onset of a major economic crisis. This relationship only came to light in 1999 when research analyst Andrew Lawrence published a report noting the odd connection between record-height buildings and noteworthy economic crises — that is, the skyscraper curse, a relationship that dated back nearly a century. Without a theory to support it, journalists largely dismissed Lawrence’s report as the fun story of the day.
However, from the vantage point of Austrian business cycle theory, or ABCT, Lawrence’s report was important for understanding the business cycle: booms and busts. ABCT is the business cycle theory developed by the economists of the Austrian school during the early twentieth century.
In the 1860s, Austrian financial journalist Carl Menger (1840–1921) began to ponder economic activity that he was reporting on in light of the economics of the classical school — that is, Adam Smith (1723–90), David Ricardo (1772–1823), John Stuart Mill (1806–73), and so on. He found huge gaps in the explanation of many basic concepts, such as supply and demand. To close those gaps he developed some fundamental elements of modern economics, such as marginal analysis and the rudiments of opportunity cost, marginal utility, and subjective value.
His students at the University of Vienna learned from him and built on his insights. For example, Eugen von Böhm-Bawerk (1851–1914), who served as finance minister of the Austro-Hungarian Empire, built on Menger’s work to show that production can be less or more time consuming, or roundabout. From this perspective, we can see that laborers get paid very quickly, while capitalists are paid interest for delaying their rewards until the product is actually sold. Böhm-Bawerk showed that interest was based on the time preferences of workers and capitalists, savers and borrowers. The interest rate is a critical economic factor because it helps determine the size and complexity of an economy’s capital structure. The capital structure is simply the non-natural world around us: all the business assets related to mines, farms, factories, utilities, transportation, warehouses, wholesale and retail businesses, and so on. Austrian economics has been described by Peter Klein as mundane economics.Peter G. Klein, “The Mundane Economics of the Austrian School,” Quarterly Journal of Austrian Economics 11, nos. 3–4 (2008): 165–87.
For example, a market economy populated with individuals with low time preferences and interest rates would, over a long period, be characterized by a large accumulation of savings that is turned into large amounts of “brick and mortar” capital and advanced-technology production processes. The division of labor would be highly specialized. People would be wealthy and have a high standard of living.
Ludwig von Mises (1881–1973) was a student of Böhm-Bawerk who extended Austrian analysis into the area of money, solving the classical school’s problem of how to connect the workings of the real economy with monetary economics. He accomplished this with his regression theorem, which was based in part on Menger’s explanation for the origin of money. Mises also formulated a theory of the business cycle based on the interaction of the interest rate and capital allocation. His approach is based on distortions of the market rate of interest. His student, Friedrich August von Hayek (1899–1992), further elaborated and extended Mises’s theory, a contribution for which he was awarded the Nobel Prize for economics in 1974. Their theory is now known as Austrian business cycle theory. (See Roger Garrison for a technical explanation of Austrian macroeconomics.Roger W. Garrison, “The Austrian School: Capital-Based Macroeconomics,” in Modern Macroeconomics: Its Origins, Development and Current State, edited by Brian Snowden and Howard R. Vane (Aldershot: Edward Elgar, 2005).)
Inspired by ABCT, my reflections about skyscrapers eventually resulted in an academic working paper, “Skyscrapers and Business Cycles.” The manuscript was summarily rejected by several mainstream economic journals. The replies from the journal editors would often include a short or cryptic explanation such as “This paper does not have a testable hypothesis.” The articleMark Thornton, “Skyscrapers and Business Cycles,” Quarterly Journal of Austrian Economics 8, no. 1 (2005): 51–74. was eventually published in the Quarterly Journal of Austrian Economics in 2005. It uses ABCT to explain how record-breaking skyscrapers are linked to business cycles and economic crises. In particular I drew on the economic theories of Richard Cantillon (1680s–1734?), the first economic theorist and a proto-Austrian economist, in order to establish causal links between skyscrapers and business cycles.
Cantillon showed how the interest rate and the money supply can create changes and distortions in the economy, a phenomenon now referred to as Cantillon effects. The paper describes three such effects: (1) the relationship between the interest rate, land prices, and building height; (2) the relationship between the interest rate, the size of firms, and the demand for office space; and (3) the relationship between building height and the enhanced incentive for advanced — or premature — technological innovations in both design and construction.
The time period of my research on skyscrapers and business cycles was crucial for my early identification of the housing bubble. In my February 2004 article “ ‘Bull’ Market?” I used a trend-channel technique to define the initial stage of the bubble. Then in June 2004 I wrote “Housing: Too Good to Be True,” a full explanation of how the Federal Reserve’s monetary policy had caused a massive housing bubble. I also began giving presentations on this subject to the general public.
As a result of this publicity, I was invited in 2005 to contribute a chapter to a book, Housing America: Building Out of a Crisis, edited by Randall G. Holcombe and Benjamin Powell. I submitted the resulting chapter, “The Economics of Housing Bubbles,” to the editors the first week of June 2006.
The publisher of the book asked me to remove some text they considered too gloomy and ominous regarding what might happen in the aftermath of the housing bust. I agreed to the changes because the book was to be marketed to people interested in zoning laws, building codes, and urban planning, not economic Armageddon. However, the editors later allowed me to include that removed text, when, after a long publishing delay, the book was finally published in 2009. At that time my gloomy predictions seemed more appropriate. The removed text was placed in a Postscript in the original publication. Indeed the editors were so kind as to mention my chapter prominently at the beginning of their preface:
The timing is noteworthy because most of the chapters were completed in 2006 when the housing boom across much of the country was reaching its peak. One chapter in particular that deserves mention in this regard is Mark Thornton’s, because he was discussing the inevitable collapse of the housing market bubble at a time when many observers were arguing that house prices could continue rising indefinitely. Thornton’s chapter does a good job of explaining the collapse of housing prices in hindsight, and it is worth noting that Thornton’s hindsight was actually foresight: he was talking about the collapse before it actually occurred.Randall G. Holcombe, and Benjamin Powell, eds., Housing America: Building Out of a Crisis (New Brunswick, N.J.: Transactions Publishers, 2009), p. vii.
Between 2004 and 2007 audiences and readers generally scoffed at my analysis. This was a time when the accepted wisdom in mainstream economics and the real estate industry was that “housing prices never go down” and “you can never lose money in real estate.” Mainstream economics refers to what is widely taught at well-known universities and associated with the neoclassical synthesis, which combines neoclassical microeconomics and Keynesian approaches to macroeconomics.
One of my particularly provocative public lectures, circa 2006, “Luxury Game Day Condominiums,” was given to students at Auburn University. As it turned out local building contractors and bankers were also in attendance. The empirical evidence I presented was based on interviews of people who had purchased these game day condos during the housing bubble. The condos had been marketed to football fans of Auburn University who come to Auburn, Alabama, for the six or seven home football games per year. When I did the calculations I discovered that the condo buyers could have stayed at the best hotel in town and eaten all their meals at gourmet restaurants and saved money. I then asked the buyers, “Why buy the condo?” To this the answer would invariably be “I can always sell it for more money later.”
The complete bust in housing had not been recognized yet, but everyone in the audience knew that condo prices were falling and that some local projects had been cancelled. The students in the audience roared with laughter at those responses, but the builders and bankers were none too pleased. Of course it was not just local builders and bankers that wanted to keep the bubble going. By now Federal Reserve officials were publically cheerleading for the housing bubble and denying that it existed.Mark Thornton, “Transparency or Deception: What the Fed Was Saying in 2007,” Quarterly Journal of Austrian Economics 19, no. 1 (2016): 65–84.
They should have known better, or at least reexamined their models. After all, the housing industry as measured by the Philadelphia Stock Exchange Housing Sector Index peaked on June 30, 2005. On August 8, 2005, my short article “Is the Housing Bubble Popping?” was published.Mark Thornton, “Is the Housing Bubble Popping?” LewRockwell.com, August 8, (2005). In the article I presented charts that indicated that home-builder stock prices could be headed much lower and that short-term and long-term interest rates could be heading higher. Both trends, which did continue, were harbingers that the housing bubble would eventually pop.
In 2007, the skyscraper curse struck again, the second occurrence since Lawrence’s 1999 report. This time it happened in the Middle East in the city-state of Dubai. Located in the United Arab Emirates, between Saudi Arabia and Oman and across the Persian Gulf from Iran, Dubai is a fantasy city. Its ruler has transformed his oil wealth into a highly dynamic city with very tall and ornate buildings, hotels, the world’s largest shopping mall, and even man-made islands in the Persian Gulf designed to resemble a map of the world.
It was in Dubai that construction of the Burj Dubai tower began in 2004. It was designed to be a world-record setting skyscraper in terms of all metrics such as height, highest livable floor, the most floors, and so on. The next “skyscraper signal” occurred when construction reached a new record height in late July 2007. In August I reported:
There is a new record setting skyscraper in the making in the United Arab Emirates. The Skyscraper Index predicts economic depression and/or stock market collapses to occur prior to the completion of the skyscraper.Mark Thornton, “New Record Skyscraper (and Depression?) in the Making,” mises.org blog, August 7, 2007.
The tower was renamed the Burj Khalifa and opened in early January 2010. The building was renamed for the ruler of Abu Dhabi who had arranged for billions of dollars in emergency loans to bail out his cousin in Dubai. Clearly the skyscraper curse had hit once again. The media began to take it more seriously. On January 8, 2010, CNN.com’s Kevin Voigt reported:
When the Burj Khalifa officially opened in Dubai on Monday, much of the world press noted the irony of the world’s tallest building unveiled just weeks after the emirate’s debt crash.
But a look at the history of record-breaking skyscrapers and business cycles suggests otherwise — the opening of every single “world’s tallest” building in the past century has coincided with an economic downturn.
One person who wasn’t surprised by the economic woes greeting the dedication of the Burj Khalifa (renamed Monday from Burj Dubai in honor of the sheikh of Abu Dhabi, which recently threw Dubai a $10 billion lifeline) was Auburn University economist Mark Thornton.
He predicted tough times for the emirate two years ago in a blog entitled “New Record Skyscraper (and depression?) in the making.” He noted that economic depression or stock market collapse usually occurs prior to completion of such skyscrapers.Kevin Voigt, “As skyscrapers rise, markets fall,” CNN.com.
So the Skyscraper Index’s “curse” has correctly forecast all major economic crises for over a century. The skyscraper curse has also experienced a good deal of mainstream media coverage; and so it would seem that the Skyscraper Index theory is accurate and alive and well.
That was until March 28, 2015, when the Economist declared the skyscraper curse was dead. In reviewing the current “skyscraper boom” they noted in their unsigned “Towers of Babel” editorial the following:
Does this frenzy of building augur badly for the world economy? Various academics and pundits, many of them cited by The Economist, have long argued as much, but new research casts doubt on it.
As a side note, the majority of major media who write about my work and this phenomenon fail to cite me as a source, although they have clearly been drawing from my publications. Of the “various academics and pundits” most draw from Andrew Lawrence.Andrew Lawrence, “The Skyscraper Index: Faulty Towers!” Property Report, January 15, 1999 and “The Curse Bites: Skyscraper Index Strikes,” Property Report, March 3, 1999. The Economist’s article did not include me explicitly in the text, but at least they did reference my 2005 journal article at the end as a source.Thornton, “Skyscrapers and Business Cycles.” Thank you.
The Economist based its view on a new academic article, “Skyscraper Height and the Business Cycle: Separating Myth from Reality.” The article was written by three Rutgers University economists: Jason Barr, Bruce Mizrach, and Kusam Mundra. It was published in the academic journal Applied Economics in 2015.
Their article demonstrates that skyscrapers do not cause (in a technical economic sense) business cycles as measured by changes in overall economic activity — that is, GDP. Their statistical analysis shows that skyscraper construction and overall economic activity move together, having a common cause or trend. They also found it difficult to find a correlation between the skyscraper announcement and completion dates and changes in GDP.
Let’s be perfectly clear here. Skyscraper construction does not cause business cycles. The statistical evidence presented in Applied Economics actually supports the Skyscraper Index theory.
It should be clear from my “Skyscrapers and Business Cycles” article that there is a third factor at work. Skyscrapers are essentially part of the boom phase of the cycle. The cause of both is artificially very low interest rates and artificially very easy credit conditions. This cause results in new record-breaking skyscrapers, a boom in the economy, and eventually a substantial economic crisis — the skyscraper curse.
Immediately, I wrote a letter to the editor of The Economist to inform them of the error in the 2015 article and to ask them to change the date they printed for my journal article from 2004 to 2005. The letter was never published and the date of my paper was never corrected. I did receive an email three months later that said the magazine had misplaced my letter. I also submitted a comment (with Lucas Engelhardt) on the article published in Applied Economics. Surprisingly, the editors of Applied Economics rejected the comment. Accordingly, this book is dedicated, in part, to the editors of Applied Economics and The Economist.
The main point of the Skyscraper Index and the resulting curse is to give people a tangible, concrete example of what is happening to the economy during a business cycle. ABCT is necessarily vague on some issues and silent on others. For example, it refers to capital, the structure of production, and goods of higher and lower orders without being specific. The theory presents issues, such as interest rates being artificially low relative to market-determined rates, without providing readers with a mechanism to calculate whether and when they in fact apply.
That does not mean ABCT is unrealistic, hard to understand, or difficult to apply. Austrian economists have always striven to be realistic about the economy and the limits of economic theory, but that necessarily puts limitations on the analysis and forces us to introduce significant caveats to our conclusions. For example, Austrian economists cannot “predict” in the strictest scientific sense. We speculate about the future, given the caveat of ceteris paribus — that is, all things being equal — and without illusions that economic theory can help us determine the timing and magnitude of future events. However, we can make “pattern predictions” based on economic theory and an appraisal of the facts.
In contrast, when mainstream economists are faced with the complexities of real economies or with scarcity of data, they resort to unrealistic assumptions, questionable simplifications, and inappropriate data. For most mainstream economists, their sine qua non is predicting the future. However, mainstream theories of the business cycle, such as real business cycle theory and various Keynesian theories, cannot predict anything about the future because in their view, the cycle is generated by economic shocks that cannot be anticipated. They can only predict in the sense that they use historical data in their models, like “back testing” stock market strategies. They practice retrodiction, rarely prediction.
The grand benefit of this book then is to show what Austrian economists see with the aid of the business cycle theory. ABCT shows what causes the business cycle, what happens during the business cycle, and that the boom must inevitably end in a bust or economic crisis. The value of resources is squandered in the process and people are harmed. Austrian theory can also show how to best deal with the bust, what to avoid, and how to permanently fix the problem by ending the business cycle, or at least minimizing its impact.
In section 2, I present evidence that demonstrates the real-world usefulness of ABCT by showing that Austrian economists have correctly forecast almost every major economic crisis for over a century. I also present evidence that mainstream economists have a poor record of predicting business cycles and have made some very bad predictions.
To be fair, there have been some mainstream economists who have made correct forecasts of economic crises, but their numbers are few compared to the Austrian economists, especially considering that Vedder and GallawayRichard Vedder, and Lowell Gallaway, “The Austrian Market Share in the Marketplace for Ideas, 1871–2025,” Quarterly Journal of Austrian Economics 3, no. 1 (Spring 2000): 33–42. have estimated that there are about a hundred mainstream economists for every Austrian-school economist. Obviously, not all predictions by Austrian economists have come true or in a timely manner, including those of this author.
Before leaving section 2, let me be perfectly clear on one key point. Austrian economists have used ABCT to make their predictions about booms and busts since Böhm-Bawerk’s time over a century ago. But since the concept of the Skyscraper Index is a relatively new concept, it has not been a part of the Austrian economists’ toolkit. The idea of the Skyscraper Index was only discovered in 1999, and the theoretical justification for connecting it to ABCT has only been around since 2005.Before ending this introduction, a question arises: what are Austrian economists saying about the current economy and government policy? Austrian economists have spoken out against current fiscal and monetary policy, and many have argued that policy has been unconventional, unorthodox, and extreme even by mainstream standards. Austrian economists have recommended drastic changes to current policies, and they have speculated that the economic consequences of the next crisis will be truly horrible. There are obviously differences of opinion, but the Austrian school is united against the current policy regime.
A skyscraper alert has already been issued, in that a groundbreaking ceremony has taken place and construction has begun on the Jeddah Tower in Saudi Arabia, a prospectively record-setting skyscraper. If a skyscraper signal is issued, it will mean that that project’s height exceeds the current world record.
In conclusion, the book provides a remedy of how to best deal with the next economic crisis.
The author would like to acknowledge the assistance and support of many people and to apologize for no doubt forgetting the assistance of many others over the long course of this project.
First and foremost I would like to acknowledge the support of the officers, members, and donors of the Mises Institute who made this book possible. I would also like to thank Paul Cwik, Harry David, David Gordon, Lucas Engelhardt, Jörg Guido Hülsmann, Roger Garrison, Karl-Friedrich Israel, Floy Lilly, Greg Kaza, Jonathan Newman, Patrick Newman, Shawn Ritenour, Louis Rouanet, Joseph Salerno, Susan Schroeder, Judy Thommesen, Paul Wicks, all the economics teachers I’ve had throughout the years. I would most especially like to thank Robert B. Ekelund, Jr.
Published 2018 by the Mises Institute. This work is licensed under a Creative Commons Attribution-NonCommercial-NoDerivs 4.0 International License.http://creativecommons.org/licenses/by-nc-nd/4.0/
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hardback edition: 978-1-61016-683-6paperback edition: 978-1-61016-684-3large print edition: 978-1-61016-685-0epub edition: 978-1-61016-688-1
Section 1 of this book has been about the Skyscraper Index, which was created by Andrew Lawrence in 1999. The index chronicles the puzzling connection between the building of record-breaking skyscrapers and the onset of severe economic crises. The resulting crises are dubbed skyscraper curses.
The skyscraper curse refers to the major economic crises that follow in the wake of record-breaking skyscrapers. In retrospect, curse is a poor choice of words. One use of curse indicates an irritation or annoyance, like psoriasis or a trouble-making daughter, distinct to the individual. A second use refers to being afflicted, at a much higher level of negativity, by a mystical being or worldly but religious person, such as a voodoo doctor. The third use refers to the use of swear words by one individual who is complaining about someone or something. The central contribution of section 1 has been to explain that the skyscraper curse is neither self-inflicted nor related to the use of curse words. It is also not about mystical beings or religious figures. The modern curse is about the imposition of severe economic harm imposed by the worldly beings at the Federal Reserve.
The Skyscraper Index has a remarkable record of showing a very close correlation between world-record-breaking skyscrapers and the onset of major economic crises. This section has extended that history back into the nineteenth century and forward in time since the index’s creation in 1999. It has also shown that the original exception to this historical record, the Woolworth Building, was not an exception at all, but simply an accident of history. We also can see that the index can be used to analyze this phenomenon at lower levels of aggregation, such as the state level and the urban level (the problem of urban sprawl).
Of course, if you had not read this section, you might have doubted the reliability of the index. As I have reiterated several times, the use of the Skyscraper Index as a forecasting tool is not highly recommended. Just as canals are no longer a central component of the economy’s transportation network, skyscrapers could easily lose their key position in the economy in the future. Another reason for caution is that major economic crises can be initiated by other causes than central banks, such as wars and pandemics. Plus, there is no precise mechanism to employ for forecasting, so there remain good reasons to be doubtful or at least skeptical in this regard.
Most promising indicators eventually fail, especially those that seem whimsical and have no fundamental basis, while others are of little use to guide long-term capital-investment expenditures. This section has provided the grounding or fundamental basis for the Skyscraper Index in economic theory and Austrian business cycle theory (ABCT). An artificially low-interest rate monetary policy pursued by central banks distorts capital-investment plans of entrepreneurs. This monetary policy follows the path from the interest rate setting policies of the central bank to open-market operations between the New York Fed and big banks. This eventually hits Main Street and results in more debt and misguided investments. We compared the natural process of economic growth and development driven by real savings with the disastrous results when apparent growth and development is driven artificially by central banks.
Most mainstream economists do not have an economic theory of business cycles. They see the economy as a simple machine that works just fine at the macro level as long as there are no technological or psychological shocks. These shocks are random and cannot be known in advance. Therefore they cannot be predicted or prevented. ABCT incorporates both technical and psychological change. Plus, ABCT theorists expect those changes to happen and can form expectations about when and where those changes will take place in the presence of artificially low-interest rate monetary policy.
By embracing the complexity of the economy with the aid of concepts such as the structure of production and the roundabout production process, ABCT can even provide insight into where the crisis will most likely be the most severe. The analysis of Cantillon effects is also helpful here because this is where the distortion causes malinvestment in product-specific capital goods. Austrian economists have disdain for magic wands in their economic analysis, whereas such wands play a crucial role in mainstream economic analysis.
We now turn our attention to the forecasting ability of Austrian economists regarding economic crises and compare that with the forecasting ability of mainstream economists. Hint: it has nothing to do with skyscrapers.
The skyscraper, that unique celebration of secular capitalism and its values, challenges us on every level. It offers unique opportunities for insightful analysis in the broadest terms of twentieth-century art, humanity, and history. — Ada Louisa Huxtable, The Tall Building Artistically Reconsidered
People have been seeking to discover the cause of the business cycle since the dawn of capitalism. For an even longer time people have sought a magic crystal ball that predicts the future. This book provides some insight for both quests.
The skyscraper is the great architectural contribution of modern capitalism, on par with the canals and railroads that transformed the economy of the nineteenth century. However, no one ever thought to connect it with the quintessential feature of modern capitalism — the business cycle. James GrantJames Grant, The Trouble with Prosperity: The Loss of Fear, the Rise of Speculation, and the Risk to American Savings (New York: Random House, 1996). did make a clear connection between real estate and skyscrapers on the one hand and the business cycle on the other in The Trouble with Prosperity, and that book could have been an inspiration to Andrew Lawrence.
In 1999, Lawrence published his Skyscraper Index, which purported to show that the building of the tallest skyscrapers coincides with economic booms. Specifically, he showed that the building of the world’s tallest skyscraper is a good proxy for dating the onset of a major economic crisis — the skyscraper curse. His index does not apply to the irregular ebbs and flows of the economy, only substantial economic crises.
Lawrence is an investment analyst whose Skyscraper Index records the history of the world’s record-breaking skyscrapers and major economic crises. According to his index, when there is a groundbreaking ceremony for a new world-record-height skyscraper the economy is booming, but when the record height is achieved a significant economic crisis soon follows. The “curse” is the economic crisis, which is usually self-evident by the time the opening ceremony occurs. The mystery is, how can record-breaking skyscrapers be connected to economic crises?
Does this represent a cause and effect relationship? Can building a skyscraper cause business cycles? Architectural historian Carol Willis describes a very similar empirical conundrum:
In the overheated speculation of the 1920s, as land prices rose, towers grew steadily taller. Or should the order be: as skyscrapers grew taller, land prices rose? The variables that contributed to real estate cycles were even more complex than this “chicken and egg” conundrum.Carol Willis, Form Follows Finance: Skyscrapers and Skylines in New York and Chicago (New York: Princeton Architectural Press, 1995), p. 88.
What is the nature of the relationship between skyscraper building and the business cycle? Surely, building the world’s tallest building does not cause economic collapse. Just as clearly, there are well-known economic linkages between construction booms and financial busts. So what theoretical connections can be made between skyscrapers and business cycles?
Lawrence considered overinvestment, monetary expansion, and speculation as possible explanations for the relationship his index revealed, but he did not explore these issues at length or come to a definitive conclusion. Instead he finished with the notion that his Skyscraper Index was an unhealthy hundred-year correlation. Without an established connection or theory for the Skyscraper Index there are strong reasons to doubt its usefulness.
For example, with the destruction of the World Trade Center and the increased threat of terrorism, the Skyscraper Index may have already lost its usefulness for prediction. However, Edward Glaeser and Jesse ShapiroEdward L. Glaeser, and Jesse M. Shapiro, “Cities and Welfare: The Impact of Terrorism on Urban Form,” NBER Working Paper 8696 (Cambridge, MA: National Bureau of Economic Research, 2001), p. 15. did not find a statistically significant link between terrorism and the numbers of skyscrapers built. They also note that because of government interventions — for example, building codes — as well as psychological reasons such as a builder’s desire for personal fame, the number of skyscrapers may not be market determined.
The business press reported on Lawrence’s Skyscraper Index, but without much fanfare. Investors’ Business DailyInvestors’ Business Daily, “Edifice Complex,” May 6, 1999. seemed somewhat sympathetic to his “impressive” evidence, but asked: “How could something bad come of building the world’s biggest skyscraper? After all, bigger is better. Having the biggest building on earth can be a source of national pride.”
Also positive was Barron’s, which seemed to agree that it was an “excellent forecasting tool for economic and financial imbalance.”William Pesek, Jr., “Want to Know Where the Next Disaster Will Hit? Look Where the World’s Biggest Skyscraper’s Going Up,” Barron’s, May 17, 1999, MW11. Business Week raised the question of how to connect skyscrapers with economic crisis as described by the Skyscraper Index.Gene Koretz, 1999. “Do Towers Rise before a Crash?” Business Week, May 17, 1999, p. 26. The first and most concerned report came from the Far Eastern Economic Review, which noted that China was planning on breaking the record for the world’s tallest building and was constructing three of the ten tallest buildings on the planet to be completed by 2010.Alkman Granitsas, “The Height of Hubris: Skyscrapers Mark Economic Bust,” Far Eastern Economic Review 162, no. 6 (February 11, 1999): 47.
The main reason for the muted response to the Skyscraper Index by the business press is that most economic indicators have eventually failed over time. There have been numerous indicators put forth to help us predict the business cycle and stock markets, but they have not passed the test of time. As Goodhart’s lawCharles A.E. Goodhart, “Problems of Monetary Management: The U.K. Experience,” in Charles A.E. Goodhart, “Problems of Monetary Management: The U.K. Experience,” in Inflation, Depression, and Economic Policy in the West, edited by Anthony S. Courakis (Lanham, MD: Rowman & Littlefield, 1981), p. 116. states: “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” This is also a likely fate of the Skyscraper Index.
For example, the Super Bowl indicator predicts that if the championship team from the National Football Conference (the old NFL) beats the championship team from the American Football Conference (the old AFL) in the Super Bowl game it should be a good year for the stock market and ipso facto a good year for the economy. This is a classic case of a “coincidental indicator.” This type of coincidental indicator (with no causal connections) should be differentiated from the traditional type of coincidental economic indicators that track changes in the business cycle. For example, payroll statistics are clearly linked with economic activity over time. If payrolls increase, then there is more economic activity and GDP. There is a real reason why we expect both statistics to change roughly in unison.
When this Super Bowl connection was first noticed in the 1970s by sports writer Leonard Koppett it was nearly perfect.Jason Zweig, “Super Bowl Indicator: The Secret History,” Wall Street Journal, January 28, 2011. Since then it has lost much of its credibility, with an overall record of about 80 percent but only about 50 percent over the last fifteen years. Therefore, the early success of the Super Bowl indicator manifested just a coincidence and a statistical illusion, as Koppett himself professed.
There are also seasonal indicators like the “January effect,” which claims that if stock markets increase in January, then stock markets will increase that year as well. However, this effect has been given multiple justifications, such as year-end bonuses and tax-avoidance strategies. It is also not clear whether the January effect is based on the performance of the stock market during the first week of January or during the entire month. It is also unclear whether it applies only to small-company stocks or the entire stock market. The January effect also suffers from the fact that once everyone is aware of it, it becomes anticipated and therefore no longer offers reliable investment advice or insight into the economy. As a result, such indicators do not have a reliable record for predicting the stock market or business cycles.
Political indicators of the economy are based on the political business cycle theory. This theory maintains that politicians will use monetary and fiscal policy, along with other policy measures at their disposal, to boost the economy, job growth, and the stock market prior to an election in order to enhance the probability of being reelected. Then after the election they will reverse those policies, creating a recession. Despite its intuitive appeal, the political business cycle theory has found little consistent empirical support. This failure may be the result of the difficulty of knowing what ruling coalition is truly in charge of government or how the different levels of government are interacting over their respective election cycles. These and other problems leave the theory with only a weak link between politics and the economy.
According to Paul Cwik,Paul Cwik, “The Inverted Yield Curve and the Economic Downturn,” New Perspectives on Political Economy: A Bilingual Interdisciplinary Journal 1, no. 1 (2005): 1–35. indicators with good causal-economic links to the economy include the inverted yield curve. When short-term interest rates rise above long-term interest rates, the yield curve becomes inverted, and this indicates trouble ahead for the economy. High short-term lending rates may indicate that borrowers are desperate for funds and lenders are reluctant to loan due to the perception of increased risk. The Index of Leading Economic Indicators was once the official crystal ball of the economy. However, in recent years it has had less success predicting changes in the economy. Two other indicators that I use to gauge the global economy are the price of oil and the Baltic Dry Shipping Index, which is a measure of the cost of ocean transportation. When both are high, it is an indication of global economic expansion, a boom, or a bubble. When both are low, it is an indication of economic contraction, a bust, or an economic crisis. However, all of these indicators are error prone and generally only provide a limited advanced notice of cyclical change. Such indicators certainly cannot issue alerts far enough in advance to be helpful for large capital-investment decisions.
Economist Richard Roll explained that economic indicators have only questionable or fleeting value for real-world investing:
I’m not just an academic but also a businessman. … [W]e could sure do a heck of a lot better for our clients in the money management business than we’ve been doing. I have personally tried to invest money, my client’s money and my own, in every single anomaly and predictive device that academics have dreamed up. … I have attempted to exploit the so-called year-end anomalies and a whole variety of strategies supposedly documented by academic research. And I have yet to make a single nickel on any of these supposed market inefficiencies.Richard Roll, “Volatility in U.S. and Japanese Stock Markets: A Symposium,” Journal of Applied Corporate Finance 5, no. 1 (Spring 1992): 29–30.
The problems with stock market and economic indicators are many. Some have a poor track record of predictions, while others have a good track record but no economic rationale and thus offer little confidence that they are not just statistical anomalies.
The Skyscraper Index, in contrast, does have a good record in predicting important downturns in the economy. This index is a leading economic indicator. The announcement of building plans — and in particular, groundbreaking ceremonies — typically occurs during economic expansions long before the onset of an economic crisis.
The most important question about the Skyscraper Index is why it has had such a good record of predictive success. Why does it work? What can it tell us about the structure of the economy over the course of a business cycle? Before we answer those questions, let us first examine the history of the index’s success in predicting the curse.
We don’t really know what starts the speculative bubbles. — Jesse Abraham and Patric Hendershott, “Bubbles in Metropolitan Housing Prices”
The Skyscraper Index was based on the most noteworthy business cycles of the twentieth century and can be explained using Austrian business cycle theory (ABCT). In contrast, there is no consensus within mainstream economics about business cycle theory. The Keynesians have several versions, but all are driven by psychology and changes in aggregate demand. This would include behavioral-finance economists such as Robert Shiller who believe that stock markets are irrational. There are also debt-cycle theories put forth by Irving Fisher, Hyman Minsky, and Joseph Schumpeter. There is the real business cycle theory (RBCT), which is associated with the Chicago school and embraces the role of external shocks, such as technological change. There is a political business cycle theory based on the election cycle, and there are even Marxist theories.
The problem with most business cycle theories is that they are really just descriptions of business cycles rather than economic theories of business cycles. Each description emphasizes particular features that are then elevated to the status of causal forces. Each stage of the business cycle is characterized by several features — for example, speculation, unstable supply of money, changes in aggregate demand, changes in social mood, and external real factors, or shocks. As a result, business cycle theories could be characterized as perspectives in which the economist has identified particular features of the economy to blame, along with their preferred remedies.
As such, business cycles are reoccurring sequences of varying length of expansions, downturns, contractions, and upturns in many types of economic activities such as production, employment, income, sales, housing starts, money, credit, and prices. Interest rates, inventories, fixed capital, and loans outstanding tend to be procyclical. Keynesian theories emphasize that business cycles must be fought with aggressive government policies, such as deficit spending, bailouts, public works projects, and monetary stimulus. Real business cycle theorists take the opposite approach and recommend a passive policy of letting the government and economy absorb the impact of external shocks.
Austrian business cycle theory has significant advantages over mainstream theories:
First, whereas mainstream theories find the cause of business cycles to be either psychological or technological, ABCT identifies a cause of the business cycle that is economic in nature — namely, artificially low interest rates, which start a chain of events that can be understood using simple economic tools, such as supply and demand.
Second, mainstream theories assume away the complexities of the real-world economy, while ABCT incorporates complexity in its analysis.Third, ABCT incorporates the psychological and technological features of mainstream theories and shows them to be predictable rather than random and unexpected shocks.
Fourth, by identifying an economic cause of the business cycle, ABCT reveals a solution for ending the business cycle and the endless cycle of psychological and technological shocks and wasted resources.
For ABCT, the cause of the boom and subsequent bust is when the central bank reduces the market rate of interest below the natural rate of interest by increasing the supply of money and credit. The natural rate of interest is the market rate of interest set by savers and borrowers in the absence of intervention by the central bank and is adjusted for both risk and price inflation. This rate, therefore, signals the general time preference of society. Artificially low interest rates are not calculable because we cannot know what the natural market rate would be except by indirect measures such as the amount of open-market operations conducted by the Fed — that is, its net government-bond purchases. However, we can understand the impact of artificially low interest rates by looking at another, more straightforward, example of a government price control — in this case, a price ceiling set by rent-control laws. Such laws keep the rental rates on apartments artificially low. These laws lead to shortages of apartments, physical depreciation of apartment buildings, and misallocation of apartments. For example, with rent-control laws, you might find a large family occupying a one-bedroom apartment and a single individual living in a three-bedroom apartment due to the shortage of apartments. The key difference with artificially low interest rates in the loanable-funds market is that the Fed can make up for any deficiencies and prevents a shortage by printing money out of thin air.
Prior to Fed involvement, the amount of savings and borrowing are equal at the market-determined interest rate. Actual loan rates of interest vary from loan to loan based on the combination of the base rate, risk premium, inflation premium, and processing costs. After the Fed has reduced this rate to artificially low levels it creates a shortage of loanable funds, which it then corrects by buying government bonds from banks for cash. Banks now have more cash, which they can use to make loans. The direct consequences of this policy are to reduce savings, increase lending and debt, and lower lending standards so that individuals with lower credit ratings obtain loans and individuals with higher scores can obtain a larger amount of loans.
For consumers this means a greater debt burden and a reduction of future income because of less saving and interest income. For entrepreneurs this means a larger amount of borrowing. The lower interest rates also make longer-term investments appear more profitable relative to shorter-term investments. For example, low rates might induce a farmer to switch from growing corn, an annual crop, to growing apples, a multi-decade-length project. Lower interest rates induce foresters to let their trees grow longer, winemakers to let their wine age longer, and publishers to have larger print runs of their books. It also induces entrepreneurs to make production structures more roundabout.
The simplest example concerning roundabout production is of an isolated person who catches fish by hand and obtains one fish per day. If that person spends one day not fishing, but instead makes a net, that person could obtain three or four fish per day. Fishing by hand is direct production, while making the net and then fishing is more roundabout.
For a more modern example, let us examine the alternative ways we can communicate with each other. The most direct way of communicating with someone is to walk over to them and begin talking. A more roundabout method would be to first run a telephone line between your location and their location and use telephones to communicate. Using phones to communicate implies the prior existence of a vast variety of capital goods for the production of wires, phones, telephone poles, and so on. The amount and complexity of capital goods for cellular phone service is even more astounding. Phones are therefore more roundabout than the “walk and talk” method, but are much more productive. Austrian economists focus on this process of technological change. Investment in more roundabout production processes means that investors are investing in new ways of doing things that were previously on the shelf but were not feasible or in general use. Spending money on research and development is investment in new technologies to be available in the future. These technologies generally involve even more-roundabout production processes. In this manner, ABCT shows how the interest rate plays a direct role in the so-called technological shocks of the RBCT.
ABCT also tries to deal with the complexity of the economy rather than assuming it away. Mainstream theories generally have a mathematical model manipulating aggregate statistics such as consumption, investment, and government spending. The mainstream approach treats capital as a homogeneous factor of production that can be retooled and relocated with a wave of a magic wand.
In contrast, ABCT examines structures of production that span from the discovery of raw materials to the final product available for sale in retail stores. There are many stages of production in every structure of production, and each stage employs specific and nonspecific labor and specific and nonspecific capital goods. For example, an oil refinery contains a multitude of capital goods that are very specific to refining oil, but also capital goods such as pipelines and tanker trucks that are nonspecific capital goods because they can be used to transport many different things. To these, the entrepreneur adds very specific labor (e.g., petroleum engineers), nonspecific labor (e.g., truck drivers), and other inputs from previous stages of production (e.g., crude oil) in order to produce gasoline, a consumer good. Therefore, ABCT can show that nonspecific capital and labor can more easily be reallocated if conditions in the gasoline market deteriorate, but highly specific capital and labor are much more difficult to reallocate. Either the market value of oil refineries and the salaries of petroleum engineers must fall dramatically or they must remain unemployed.
The structure of production of all goods and services is highly complex. It is so complex that mainstream economics assumes it away. Even being complex, we can know some things about it and some things that affect it. The structure of production of a new product begins with a very short and direct structure. For example, with the invention of the automobile hundreds of small companies started making their own hand-fitted parts and assembling cars one at a time.
My first “portable” computer was built just for me by a computer technician using purchased parts, and it was the first one in town. This “portable” was the size of a suitcase that would barely fit in the overhead compartment of an airplane and weighed almost twice as much as a fully packed suitcase. Over time structures of production tend to get longer and the number of companies that sell the final consumer product often decreases.
For example, mass-produced interchangeable parts and the assembly line production technique for automobiles were introduced and quickly adopted. These technologies made production more efficient and increased the specialization of labor. They also made the structure of production more roundabout: machines had to be created to make interchangeable parts and assembly lines, technologies had to be created to replicate those machines, and so on. Today we find the structure of the automobile industry incredibly complex, with thousands of firms spanning the globe. These firms provide everything from computer graphics software to design new automobiles to the caps for the air valves on tires. Parts are transported to assembly factories, and then automobiles are shipped to auto dealerships. For mainstream economists the idea of perfect competition is the initial chaos of thousands of individual automobile companies, while for Austrians the whole process of the initial chaos evolving over time into a small number of mega-sized automobile manufacturers is competition. Mainstream economics’ ideal market form requires a large number of buyers and sellers, perfect information, a homogenous product, and several other conditions. For Austrian economists the only requirement for competition is no government barriers for entrepreneurs entering or exiting an industry.
Another difference between Austrians and mainstream economists concerns the role of money. For the mainstream economists money is neutral and is similar to their view of capital. Money can be injected into any point in the economy and it will not cause disruptions, distortions, or redistributions of wealth. In other words, new money does not affect the real economy or relative prices. For them it only raises the so-called price level and reduces the purchasing power of money. In the mainstream view, new money seamlessly seeps throughout the economy without resulting in any relevant changes in demands, relative prices, or production.
In contrast, Austrians base their analysis on the real impacts money can have on the economy. Let us contemplate a doubling of the money supply in the economy, as Richard Cantillon did in 1730. He concluded that new money could not possibly be neutral and then gave several examples of new money and how it would disturb an economy and cause redistributions. His examples included the discovery of silver mines and a large number of wealthy immigrants moving into a nation with their money. He showed that new money changes prices and production to meet the new demands of wealthy mine owners, miners, and new immigrants.
Our example is a central bank that wishes to try an experiment with newly printed money. After carefully acquiring the names of all pickup truck and NASCAR enthusiasts in the economy, it credits each of their bank accounts with $10 million. Austrian economists would expect to see ticket prices for the Daytona 500 increase dramatically, and they might speculate about the introduction of a Daytona 1000, but mainstream economists would expect no change. Austrian economists would expect that the price of the Ford F-450, the most expensive pickup truck in the market today, would increase and that Ford would produce a larger quantity of such trucks and might even build a new assembly plant or even design more expensive versions of its line of pickup trucks.
The pickup truck and NASCAR enthusiasts, the Daytona 500, and the pickup truck producers would all gain relative to everyone else. However, when all the money was spent, what would happen to the new capital that the Daytona 500 and Ford have invested? Mainstream economists tell us that there would be no effect on incomes, wealth, production, and new products or that any such disturbance would only be short lived and unimportant.
In recent years, the Fed’s use of zero–interest rate policy (ZIRP) and quantitative easing (QE) has made it possible for hedge fund managers, Wall Street bankers, and bond dealers to become extraordinarily wealthy. As a result of this immense wealth, real estate prices in Manhattan have increased dramatically and many new luxury-condo skyscrapers have been constructed. The experience at art auctions also tells a similar story. The price of artwork of artists of the currently fashionable contemporary-art genre, such as Jean-Michel Basquiat, Christopher Wool, and Jeff Koons, has skyrocketed to millions of dollars, while the minor works of such famed artists as the impressionist Pierre-Auguste Renoir can be purchased for perhaps less than $100,000.
In reality, with conventional monetary policy there are some straightforward ways in which the economy is distorted by artificially low interest rates. There is more lending and investment and entrepreneurs tend to favor longer-term, more roundabout means of production. For example, in the current environment of extremely low interest rates, especially for large corporations, Amazon has found it profitable to use robots rather than employees to fulfill orders from customers, despite the low-wage environment. The most direct way to fulfill orders is to have employees read orders, retrieve products, and package the products for delivery. A more roundabout method would be to design and build robots to replace the employees; create software for the robots to fulfill orders; reorganize warehouses and order-fulfillment centers to operate with robots; and train some employees to maintain and interact with the robots.
To watch the robots move around Amazon facilities, one might get the feeling that the company is somehow cheating on its various competitors. Additionally, when one looks at the price of Amazon stock one might guess that the company is earning huge profits, akin to a worldwide monopoly. Sales in 2015 were an enormous $35.7 billion, up 22 percent over 2014. Profits were also up a staggering 125 percent at $482 million in 2015. However, that means they are only making about 1 percent profit on sales. Amazon has a market capitalization of $300 billion and a price-to-earnings ratio of over 500.David Goldman, “Amazon Shares Plummet as Profit Disappoints,” CNN.com, January 28, 2016. In other words, investors cannot imagine anything going wrong for the company. WilsonDavid Wilson, “Cisco, Apple Fail to Reach $1 Trillion. Is Amazon Next?” Bloomberg.com, May 9, 2016. reports that one analyst predicts the company will be worth $3 trillion in less than ten years.
Some of the conventional disturbances caused by an increased money supply include a redistribution of wealth from savers to borrowers because borrowers obtain loans at lower rates, savers get a lower return on their savings, and the value of savings and debt is diminished by price inflation. The biggest beneficiary of this redistribution is the federal government, which has trillions of dollars of debt. The other primary redistribution from an increased money supply is the redistribution from people working for wages or living on fixed incomes to people with variable incomes, primarily but not exclusively in the financial sector.
Keynesian business cycle theories are based on psychological factors while real business cycle theory rests on external shocks such as technological change. ABCT incorporates both psychology and technology. With artificially low interest rates the economy will experience more investment and consumption. The price of assets will increase and unemployment will fall, even below the so-called natural rate of unemployment. Wages, incomes, and profits will all increase. During this boom Austrians expect the psychology of investors and entrepreneurs to be highly positive. Retirement stock accounts will increase substantially, variable-income workers in the service economy, such as waiters and massage therapists, will earn higher incomes, and novices will earn windfall incomes by endeavors such as flipping houses and day trading stocks. Given the above story about Amazon, it would also not surprise Austrians that a great deal of new technology would come about; in fact with ABCT it would be expected. The very nature of making an economy more roundabout implies new recipes for production and the introduction of new technologies. So there is a built-in rationale for a technology shock during a boom.
Every boom eventually peaks, and then the economy enters into a corrective phase, or bust. The reasons for transition are important and will be discussed, but for now let’s stick to our example of the bust phase; in light of the mainstream business cycle theories, this is largely just reversing aspects of the boom phase. The price of assets will fall, and the unemployment rate will increase above the natural rate. Wages, incomes, and profits will fall, and the incomes of service workers will decline. House flippers will flop. Naturally the positive psychology of the boom will disappear and the social mood will turn gloomy. Austrians expect this to happen. We would be very surprised if it did not happen.
In terms of technological change, it is hard to undo technology once it is introduced, so Austrians generally expect large losses where there had been the largest investments in new technology, the real estate related to that new technology, and the people who financed that new technology. Some RBC theorists argued that the financial technology used in the housing bubble was responsible for both the bubble and the bust. They blamed the new financial instruments, such as collateralized debt obligations, mortgage-backed securities, and asset-backed securities. For RBCT this financial technology was both a positive shock up to 2007 and then a negative shock. Indeed, the financial technology is the primary, but not only, reason why it was, after all, a housing bubble. Without these new financial products, Fannie Mae, Freddie Mac, the Community Reinvestment Act, and the tax advantages of homeownership, it would have been simply a generalized bubble throughout the economy, rather than specifically a housing bubble.
For now let us look first at the process of economic growth and contrast it with the business cycle in light of ABCT. It is important to know that true economic growth is dependent on the existence of increased savings. When people spend less of their income on consumption goods and save their money, they leave more resources in the economy to be used by others. As compensation, they will have more savings and interest income so that in the future they can increase their consumption beyond their income, or even forgo working altogether.
Entrepreneurs need savings, whether it is acquired through bank loans, the sale of stocks and bonds, or retained earnings from their companies. They need money to acquire capital goods, to hire labor, and to pay other expenses. Companies will use savings to maintain their capital from physical depreciation and they will invest in new capital goods that present better profit opportunities because of technological advantages. This will make the production structures more roundabout, efficient, and productive. More savings makes it possible to pay for things such as more employee payroll and inventories prior to the consumer ultimately paying for the final product. In other words, all the resources hired and used from the acquisition of raw materials to the final assembly and sale of consumption goods have to be financed in some way. More savings results in greater productivity and production.
Now let us contrast economic growth with the business cycle. Instead of an increased preference for saving and future income, now the lower interest rate and source of new loanable funds comes as a result of the monetary policy of the central bank. At the lower interest rate people will save less, not more. They will consume more. Investment will increase, particularly in longer-run, more-roundabout production technologies, but also for consumption purposes.
Reducing saving and increasing consumption and debt makes consumers less wealthy and puts them in a more precarious economic position. Investing in more-roundabout production processes also puts entrepreneurs in jeopardy. For example, instead of two entrepreneurs developing two new factories for the production of new advanced computer chips, four such projects are proposed and financed at the artificially low rates. The entrepreneurs study their projects, which are not identical but are very similar, in order to determine where to construct such factories and what are the best places to find construction workers, engineers, scientists, and factory workers. Also, what are the best sources of the very-specific capital goods, such as chip-making machines and clean-room technology? With existing chips selling better than expected due to increased consumption in the economy and promises of a new advanced chip on the way and financed at low interest rates, the stock price of these companies goes much higher. With such activities happening in many industries, the economy is booming.
Now we turn our attention to supply and demand issues as the entrepreneurs start running into some unforeseen circumstances. With twice the normal number of factories under construction, the price of land best suited for the factories is higher than expected. The availability of labor — first construction workers, but eventually the engineers, scientists, and factory workers — is less than anticipated and therefore wages and benefits are higher than were projected. The demand for the advanced chip-making machines and clean-room technology is also much higher than anticipated, so their prices are also higher than expected. Because there are four factories instead of two, the cost of all four projects will be higher than anticipated. Some components of the projects could be ordered in advance to avoid such cost increases, but not all them.
As the factories come online and start producing, other problems arise. The industry-wide supply of advanced computer chips is much greater than the entrepreneurs originally anticipated. As a result, the price of such chips falls and is lower than anticipated when the projects were initiated. The result of having undertaken four projects instead of two is that prices and revenues are lower than anticipated. Computer chips can be sold in advance too, but such hedging provides only short-term protection.
The overall demand for such an advanced computer chip is also likely to be adversely affected by the artificial interest rates. Recall that artificial rates increased consumption and reduced saving. This means that consumers were busy buying things such as the previous generation of smart phones and other chip-containing products, but now they have less savings and more debt. If half of your intended consumer base now has $10,000 in credit card debt and only $100 in their checking accounts, there is going to be a reduced demand for new chip-containing gadgets. This means fewer chips sold and even lower prices. The central bank can try additional doses of artificial credit, but it cannot print resources. It can only create more malinvestments and greater consumer debt. Notice that if there is a general glut of production capacity in an economy the result could be price deflation, the bogie man for mainstream economists.
With market-determined interest rates, an increase in the demand for loans by chip-making companies and entrepreneurs more generally would result in higher interest rates. When the interest rate is determined by the central bank, there is nearly a perfectly elastic supply of loans at the policy interest rate.
You can see the impact of artificially low interest rates today in the boom in higher orders of capital goods: the record-setting stock markets and general weakness in goods of the lowest order, consumption goods. Central bankers have feverishly used their one tool of money printing, but that has only created asset bubbles, malinvestments, and relative weakness in the Consumer Price Index, which is what ABCT expects. Once central bankers give up and put away their tool, asset prices will crash, malinvestments will be revealed, and consumer prices will be relatively strong.
Some might wonder here about the Austrian view of entrepreneurs. How can the same people who can figure out such amazing ways of improving the economy and its structures of production be fooled, repeatedly, by the Fed? Yes, Austrian economists do view the entrepreneur as a critical player in the economy, but entrepreneurs are not omniscient and we expect them to fail on a regular basis, constrained and controlled by competition, the system of profit and loss, and their capitalist backers. Engelhardt shows how easy credit conditions provide low-quality entrepreneurs access to credit that they would not have access to under tighter credit conditions.
In a nutshell, ABCT warns that artificially low interest rates create malinvestments and a boom or bubble in the economy. This necessarily sets the stage for a recession, bust, or economic crisis when the cluster of entrepreneurial errors is revealed. This is an economic business cycle theory, although it anticipates and incorporates the technological shocks and psychological instability of the competing mainstream theories. ABCT shows us how the biggest policy errors by the central bank result in economic crises and skyscraper curses and more entries in the Skyscraper Index.
[Full Issue of the Quarterly Journal of Austrian Economics 20, no. 4 (2017)]
ABSTRACT: I comment on the controversy around Garrison’s secular growth, with special emphasis on Murphy’s contribution in this issue. I also argue that further research on this area should focus on formally connecting Garrison’s model with neoclassical growth theory.
KEYWORDS: business cycle, Austrian School, GarrisonJEL CLASSIFICATION: B53, E321. INTRODUCTIONThere has been an ongoing debate for some time now on whether or not (Garrison, 2001) secular growth is consistent with neoclassical growth theory, in particular with Solow’s model (Engelhardt, 2009; Salerno, 2001; Young, 2009a, 2009b). Murphy’s paper included in this issue is the latest contribution on this issue. This short comment clarifies the issue and some of the arguments involved. First, I present the controversy around Garrison’s secular growth. Then I comment on Murphy’s counter-examples. Finally, I offer a short reflection on how to move forward with respect to growth and Garrison’s model if the intention is to engage the neoclassical literature.
- THE CONTROVERSYGarrison (2001, p. 54) presents the case of secular growth in the following way (italics added):
While a no-growth economy allows for the simplest and most straightforward application of our graphical analysis, an expanding economy is the more general case. Secular growth occurs without having been provoked by policy or by technological advance or by a change in intertemporal preferences. Rather, the ongoing gross investment is sufficient for both capital maintenance and capital accumulation.
The objections to Garrison’s exposition rest on understanding “secular growth” as a long-run phenomenon. This contrasts with the well know result of Solow’s model that in the long-run the economy grows at the rate of total factor productivity (TFP). The main reason for this is that capital presents diminishing marginal returns and there is a constant depreciation rate. These plausible assumptions mean that in a growing economy, eventually the capital stock is just too large for the marginal productivity of capital to replace and increase the stock of capital. Given consumers’ time preference, the economy can just replace the depreciated capital. This is the stationary (equilibrium) point. Salerno (2001) argues that Garrison’s secular growth is inconsistent and is implicitly making use of questionable assumptions. Young (2009a) rests on Solow’s model to argue that Garrison’s position is inconsistent. Engelhardt (2009) and Murphy’s paper hold the opposite position, arguing that there is a case for secular growth in capital based macroeconomics.
2.1. From Engelhardt-Young to Murphy
Contra Young (2009a), Engelhardt (2009) argues that all that is needed for secular growth to be possible is that “some form of nondepreciating capital is produced” (p. 60.) For instance, intangible capital or ideas are not forgotten after being produced (a form of nondepreciating capital) (pp. 61–62). However, Young (2009b) points out that Engelhardt’s argument requires us to assume not only nondepreciating capital, but also constant marginal returns on capital. Even without depreciation, decreasing marginal returns means that the growth of output converges to zero. In other words, Engelhardt’s argument implies that Garrison’s secular growth is the analogous to the AK model in neoclassical growth theory. The distinctive characteristic of the AK model is that capital depicts constant marginal returns.
Murphy argues that Young’s position falls once we consider the time involved when there is no capital depreciation. Because of this, Murphy argues, neoclassical economists may side with Garrison’s secular growth rather than Salerno’s and Young’s objection. Murphy’s objection to Young rests on a different understanding of secular growth. In Murphy’s treatment, secular growth is a short-run (in the economic sense) phenomenon even if it is a long-term period on the eyes of economic agents. Consider, for instance, the use of the term “secular stagnation” to describe a long-term period of lack of economic growth. Therefore, before reaching the steady state, the existing capital stock might be enough to both maintain and accumulate capital. If this is the case, most of the controversy surrounding Garrison’s secular growth is built on a semantic misunderstanding. But, Murphy’s examples show that there may be more than just semantic quibbles. His examples show how scenarios of secular growth are still possibly consistent with neoclassical growth theory.
- MURPHY’S SCENARIOSThe first example given by Murphy is the more counterintuitive one. In Solow’s model, capital shows diminishing marginal returns at the same time that capital depreciates at a constant rate. What Murphy is showing is that by assuming a zero depreciation, then net investment changes in a way that secular (meaning perpetual) growth is possible. If there is no need to allocate a portion of the savings to maintain capital, then the capital stock grows exponentially at a rate that perfectly compensates for the diminishing marginal returns of capital. Because of this, output can grow indefinitely at a constant absolute rate. Note that output depicts diminishing returns to capital but constant returns over time (because of the exponential growth of capital over time). As Murphy recognizes, this scenario is not the most interesting one. To assume a zero-depreciation rate for all capital is implausible. Even if intangible capital presents no depreciation, as long as there is some physical capital with a positive depreciation rate, the total capital stock will have a positive depreciation rate. The role of this example is to show the effect on capital accumulation when the depreciation rate is assumed to be zero.
Murphy’s second example assumes a positive depreciation rate for capital stock. It is in this scenario where the semantic issue of defining “secular” growth becomes important. As long as there is a depreciation rate, then the capital stock cannot grow fast enough to maintain a constant growth of output with respect to time. Without a depreciation rate, there is no steady state. But in scenario two, there is a steady state and therefore growth cannot be perpetual without TFP increases. However, if the time required to reach the steady state is long enough, then such situation could be described as secular growth. This, of course, requires an arbitrary definition of how long is too long. This is why is important to understand secular growth as something different than perpetual growth.
It is possible that Garrison has in mind a similar definition to Murphy’s. Chapter 4 (p. 57) in Garrison’s book starts the following way: “Secular growth characterizes a macroeconomy for which the ongoing rate of saving and investment exceed the rate of capital depreciation.” This definition, however, comes after the discussion of the case of secular growth (pp. 54–56). The discussion in the secular growth section invites the interpretation that Garrison might be talking about perpetual growth. Certainly, neither Young nor Salerno nor Engelhardt can be blamed for misunderstanding Garrison.
- WHAT TO DO NEXT, IF ANYTHING?Whether or not Austrian business cycle theory academic research should be based on a pedagogical tool as Garrison’s model is open to debate. However, taking as given the use of Garrison’s model, what can be done next in terms of compatibility with neoclassical growth theory?
Rather than focus on semantic disputes, an actual expansion of Garrison’s model to account for different growth models would be more fruitful both in terms of theoretical and empirical studies. This, however, requires to follow a path that may look “un-Austrian,” which consists in formally representing Garrison’s model (Cachanosky and Padilla, 2016). This formal representation of Garrison’s model, however, is not that far away from what is already being done in this line of research. The mere fact of using Garrison’s graphical model means that the equations behind the graphs are also being endorsed. A mathematical version of Garrison’s model is the other side of the graphical version of Garrison’s model. But the mathematical side of the model allows for a more flexible exposition of a more complex model for which a set of graphs may be too restrictive.
By adding time and a neoclassical production function, Garrison’s model is connected with a simple growth model. For instance, a Solow-Garrison model can track what happens to the Hayekian triangle and the stages of production when the Solow model faces different shocks (growth in TFP, changes in time preference, etc.). Conversely, it allows us to see what happens to the Solow model if there is a monetary policy that puts into motion unsustainable growth. The following natural step to engage the neoclassical literature would be to illustrate the insight of a Solow-Garrison model with empirical research. This is just an example of how the controversy around Garrison’s secular growth may lead to new research originating in Garrison’s important contribution.
[Full Issue of the Quarterly Journal of Austrian Economics 20, no. 4 (2017)]
ABSTRACT: According to Hayek’s “theory of the Ricardo Effect” there is a “decline of investment” on the part of the consumer goods industries that starts halfway through the cyclical upswing. This “decline of investment” then gradually leads to the “scarcity of capital” in the consumer goods industries, which is the proximate cause of the upper turning point. This thesis was hardly made convincing by Hayek. I develop the theory of the Ricardo Effect by rebuilding it around the alternative theses that a decline of investment by both the machine producing industries and the raw materials industries leads to the “scarcity of capital.”
KEYWORDS: Ricardo Effect, Austrian Business Cycle Theory, upper turning point, circularities, structure of production JEL CLASSIFICATION: D24, D25, E14, E22, E32 , E51, G31 1. INTRODUCTION The concrete thesis in Hayek’s theory of the Ricardo Effect is that the business cycle’s upper turning point is brought about by a decline of investment in fixed capital on the part of the consumer goods industries, a decline that starts during the upswing. To Hayek, the upswing begins with a credit-induced “acceleration effect,” a somewhat exaggerated demand for machinery by the consumer goods industries. Roughly halfway through the upswing, falling real wages make investment in machinery less attractive. This is the “Ricardo effect,” which counteracts the acceleration effect. The decline of investment, on the part of the consumer goods industries, commences. Labor is reallocated from the machine producing industries to the consumer goods industries, because the funds destined for capital expenditure are reallocated to additional operating expenditure. There is increased capital utilization in the consumer goods industries in the latter half of the upswing, which initially strengthens the boom. However, the decline of investment leads in the longer run to a crisis, because machines in the consumer goods industries are not replaced once worn out, or only replaced by less-labor saving machinery. This eventually causes a diminished productive capacity in the consumer goods industry, a “scarcity of capital.” The decline in investment spending leads, of course, also to a slump in the machine producing industries.
Hayek’s thesis that a decline of investment by the consumer goods industries would take place, starting roughly halfway through the upswing, was hardly made convincing by him. His theory of the Ricardo Effect has generally not been well received (Klausinger, 2012, pp.15–24). I also believe that this concrete thesis is largely incorrect. But when Hayek’s theory of the Ricardo Effect is looked upon more broadly than by just focusing on this concrete thesis, I believe it contains a lot of material that would support an alternative thesis that very much resembles Hayek’s thesis.
In this paper I develop Hayek’s theory of the Ricardo Effect by rebuilding that theory around the alternative thesis that a decline of investment by the machine producing industries leads to the “scarcity of capital.” This means to visualize the Ricardo Effect not as an economy-wide shift of workers from the machine producing industries towards the consumer goods industries, but as a re-allocation of productive capacity within the machine producing industries itself. Instead of the “acceleration effect” becoming dominated by the “Ricardo effect” in the second half of the upswing, I will twist Hayek’s argumentation a bit. I will argue that the “acceleration effect,” which emanates from one half of the economy (the consumer goods industries), gives rise to the “Ricardo effect” in the other half of the economy (the machine producing industries). I will also attempt to demonstrate a secondary thesis on top of this primary thesis. This secondary thesis is that, because the “acceleration effect” causes the machine producing industries’ capacity to become fully employed, continued credit expansion will lead, somewhere halfway the boom, to increasing operating expenditure by all industries. This increasing operating expenditure will drive towards a Ricardo Effect in the raw materials industries, causing an increasing scarcity of “circulating capital,” and finally flipping over the upswing into the downswing.
The rest of this paper is organized as follows. In the following section I will summarize Hayek’s theory of the Ricardo Effect with more detail than in this introduction. Here I will also highlight the main points of the debate over the Ricardo Effect in the early 1940’s, and I will highlight the main capital-theoretic problem that Hayek deals with in his theory of the Ricardo Effect. In the third section following that, I provide a list of points on which my development of the theory of the Ricardo Effect originates in Hayek’s theory. The fourth section can be seen as the core of this paper. It deals with a conceptual difficulty of the stages-of-production model that Hayek recognized in his theory of the Ricardo Effect ([1935] 2012, pp. 223–226). The difficulty is that of so-called “circularities” in the structure of production, in particular how to model these circularities verbally or graphically. Hayek did not really resolve this difficulty and I will attempt to do so by re-examining the capital-theoretic issue of combining the intertemporal stages-of-production viewpoint with the cross-sectional viewpoint that divides the economy into a consumer goods industries and a machine producing industries. Here I propose a new type of cross-sectional model that should better help understand the near-future/distant-future trade-offs. In section five I will argue in detail for my primary thesis and therefore go into the reasons why a Ricardo Effect (i.e. a decline of investment) would occur within the machine producing industries during the boom. In the sixth section I will come to my secondary thesis, and I will argue that the increased capital utilization that appears during the boom leads to a Ricardo Effect in the raw materials industry. Hereto I will extend the cross-sectional viewpoint that divides the economy into a consumer goods industries and a machine producing industries with the raw materials industries as a third sector.
- A SUMMARY OF HAYEK’S THEORY OF THE RICARDO EFFECT AND ITS PROBLEMS 2.1 Hayek’s Revised Business Cycle Theory
Profits, Interest and Investment ([1939] 2012) and “The Ricardo Effect” ([1942a] 2012) Hayek published what may be called his “theory of the Ricardo Effect” (Wilson, 1940, p.171).Apart from these two essays Hayek’s theory of the Ricardo Effect can also be seen to be restated in two short replies to Kaldor ([1942b] 2012). Also, without using the term “Ricardo Effect,” Hayek raised similar points in chapter XXVII of The Pure Theory of Capital ([1941] 2009) and in “Full Employment Illusions” ([1946] 2009). Then he returned to the issue roughly a quarter of a century later in “Three Elucidations of the Ricardo Effect” ([1969] 2012). Profits, Interest and Investment was partly a revision of his business cycle theory of Prices and Production ([1935] 2008) in order to provide a more detailed explanation of the upper turning point of the business cycle. Hayek identified as a main difference with his earlier explanation of crises that in his “revised version” he believes that “a rate of profit rather than a rate of interest is the dominating factor in this connection” ([1939] 2012, p. 212). Hayek would initially assume the rate of interest as given, which apparently implies that the supply of credit is simply “elastic” and that there is a credit expansion going on throughout the upswing (ibid., p. 230). Hayek attempts to demonstrate that “the turn of affairs will be brought about in the end by a “scarcity of capital” independently of whether the money rate of interest rises or not” (ibid.). Professor Klausinger has explained the importance of these revised aspects:
The new features of the model—in comparison to Prices and Production—are crucial for the novel explanation of the upper turning point. For without an elastic supply of credit and with the circulation of money limited, eventually the rate of interest would rise sufficiently to choke off investment demand […] what Hayek is now attempting to demonstrate is the inevitability of the breakdown of an inflationary boom, even […] with unlimited credit creation and with less than full employment. (2012, p. 17, footnote omitted.)
Because Hayek would concentrate on the latter half of the upswing, he was brief about the first half. He simply asserted that in the first half of the upswing, credit expansion and increasing consumer spending would give incentives to the consumer goods industries to order more machinery. This more or less exaggerated ‘derived demand for machines’ Hayek called the “acceleration effect,” following the terminology of “a well known doctrine, the so-called ‘acceleration principle of derived demand...’” (Hayek, [1939] 2012, pp. 222–223). However, Hayek did not quite follow that doctrine itself till the end.
Hayek assumed that “at a point somewhere half-way through a cyclical upswing […] prices of consumers’ goods do as a rule rise and real wages fall” (ibid., p. 217). On this Hayek builds his concrete thesis: At this halfway point the incentives for entrepreneurs are strong enough to:
...make the tendency to change to less durable and expensive types of machinery dominant over the tendency to provide capacity for larger output. Or, in other words, in the end “the acceleration principle of derived demand” becomes inverted into a “deceleration principle....” (ibid., p. 231)
Besides calling this weakening ‘derived demand for machines’ simply a “decline of investment” (ibid., p. 230), Hayek also calls this tendency the “Ricardo effect.” In short, the “acceleration effect” dominates the first half of the upswing, the “Ricardo effect” the second half.
Hayek’s visualization of this Ricardo Effect is that while the consumer goods industry decreases its capital expenditure, it will start to increase its operating expenditure. Workers are then re-allocated from the machine producing industries towards the consumer goods industries. Fewer machines, or “less durable and expensive types of machinery,” are manufactured in the machine producing industries, while machine-utilization in the consumer goods industries goes up ([1942a] 2012, pp. 275–276). However—this seems to be Hayek’s point—higher machine-utilization can only sustain higher output for as long as those machines are not yet worn out. Since less machines are manufactured to replace worn-out machinery, there must come a point at which that higher output cannot be maintained. The decline of investment results in a decreased productive capacity, and “the classical maxims that a scarcity of capital means a scarcity of consumers’ goods […] assert their fundamental truth” ([1939] 2012, p. 231). The relationship to the business cycle of this theory of the Ricardo Effect is that this “scarcity of capital” becomes the real reason why the high level of output during the boom-phase cannot be sustained (ibid., pp. 230–232). The upswing must reach a “turn of affairs” (ibid.). Besides this, the decline of investment by the consumer goods industries would, of course, also lead to a slump in the machine producing industries.
2.2 The Debate on the Theory of the Ricardo Effect
The debateOther summaries of the debate can be found in Haberler (1943), Blaug (1997) and Klausinger (2012). Klausinger (2012) is the introduction to the 8th volume of Hayek’s Collected Works in which most of the theory of the Ricardo Effect can be found. Klausinger (2011) provides some more background to the debate. For example, Wilson, Kaldor, and Hayek were all attached to the London School of Economics during the debate, Kaldor being Wilson’s thesis supervisor. that followed, between Wilson (1940), Hayek ([1942a] 2012) and Kaldor ([1942] 2012), centered around the rather micro-economic question of what firms in the consumer goods industries would do under the circumstances that Hayek described. Wilson compared Hayek’s thesis, that “with a perfectly elastic supply of credit, a fall in real wages will lead to the adoption of less roundabout methods of production,” to a treatment of a similar case by Kaldor (Wilson, 1940, p. 173). To Kaldor, a representative firm would combine, in the words of Wilson, “direct labour and indirect labour […] in the same proportion as before; the change in prices will change the scale of output but leave the degree of capital intensity unchanged” (ibid., p. 174; cf. Kaldor, 1939, pp. 49–50). Kaldor’s conclusion was that the method of production (i.e. the ratio of direct to indirect labor) at which profits are maximized, in the case of elastic credit, will be entirely determined by the interest rate. The real wage rate has no influence. The reason is that falling real wages (selling prices that go up relative to money wages) do not affect the initial costs (expenses on wages for indirect labor plus interest charges) of each different method of production (Wilson, 1940, p. 177). Hence, under elastic credit and falling real wages, such a representative firm would would not change its “ratio of indirect to direct labour” (ibid., p. 176). But it would hire more indirect labor and direct labor in the same proportion as it did before. In other words, it would purchase more machines similar to what it already has, and also hire more workers to man those machines. The representative firm enlarges its scale of operations by “capital widening.” With respect to the consumer goods industries as a whole, this means that maximum aggregate profits are achieved when each consumer goods firm enlarges the scale of operations on its particular profit-maximizing “ratio of indirect to direct labour” until for each firm marginal revenue will have equaled marginal costs (ibid.; cf. Klausinger, 2012, p. 19). In the aggregate of the consumer goods industries this means, as Professor Klausinger has explained, that “the increased demand for consumers’ goods will bring forward ‘capital widening’ but no ‘capital enshallowing’...” (Klausinger, 2012, p. 19). Wilson pointed to the crucial role of Hayek’s assumption of a perfectly elastic supply of credit, which would play an important role in the rest of the debate. Even if that assumption is dropped, Hayek’s thesis would not stand, according to Wilson. Under a rising supply schedule of credit, he argued, an increase in consumption may diminish capital intensity (there will be less use of indirect labor relative to direct labor), but it will not lead to a fall in investment (less use of indirect labor in the absolute) (ibid.).
Hayek subsequently defended his case in “The Ricardo Effect” ([1942a] 2012). Instead of discussing a choice among a number of different ratios of indirect to direct labor, Hayek now built his argument on the more practical idea that entrepreneurs must choose between “expenditure on wages (or investment in ‘circulating capital’) and expenditure on machinery (investment in ‘fixed capital’)” (ibid., p. 262).Increasing capital utilization is not exactly the the same as increasing the ratio of direct to indirect labor (i.e., decreasing the “ratio of indirect to direct labour”). The former means that existing machines will be utilized more intensely, the latter that replacement machines which are to be built will be “less automatic” than the machines they will replace. These two concepts are intertwined in the theory and debate on the Ricardo Effect. Of course, they may have something to do with each other if increased capital utilization of the consumer goods industries is made possible by shifting labor away from the machine producing industries, leaving the latter with less manpower to built more automatic machines. This was precisely Hayek´s thesis. Hayek maintains that in the upswing at some point entrepreneurs prefer to use their funds to increase output by increasing the utilization of their existing capacity rather than by purchasing more capacity. The obvious objection against Hayek’s line of argumentation was raised by Hayek himself: “To this it will no doubt be answered that there is no reason why the entrepreneurs should not do both: provide for the output in the near future by the quick but expensive methods and provide for the more distant future by ordering more machinery” (ibid., p. 278). Kaldor indeed responded in such a way:
When the price of a product rises (or strictly: the expected price of the product rises) it becomes profitable to increase output, and to extend output-capacity, until the expected price, or the marginal revenue, is back again to conformity with cost. As Ricardo said: “an unusual quantity of capital would be employed till their price afforded only the common rate of profit”.... ([1942] 2012, p. 296)
Hayek must show what is precisely that thing that propels entrepreneurs in the consumer goods industries to only increase operating expenditure when demand for their product rises. Increasing output by increasing capital utilization can only go so far. There are capacity constraints in the consumer goods industries which can only be lifted by purchasing additional machinery. Under the circumstances that Hayek initially stipulated—an “elastic” availability of credit and increasing consumer spending—there should be ample room to also increase capital expenditure and install more capacity. Output would be increased by a combination of operating expenditure and capital expenditure, contrary to Hayek’s claim that there is a tendency to shift to operating expenditure only (Haberler, 1943, p. 490).
This brings us to the one point on which Hayek is seen as having admitted defeat (Klausinger, 2012, pp. 21–22). For in “The Ricardo Effect,” Hayek retreated from his assumption of an elastic supply of credit during the upswing, towards the assumption that “every prospective borrower will have to face an upward sloping supply curve of credit” ([1942a] 2012, p. 270). Hayek argues that the funds in the hands of entrepreneurs are limited and that therefore operating expenditure will at some point in the upswing be increasingly preferred above capital expenditure. This change of assumption implies that a decline of capital expenditure by the consumer goods industries—if that indeed happens during the upswing—occurs mainly because the supply of credit is drying up, rather than that the rate of profit on investment in fixed capital is declining vis-à-vis investment in working capitalNote that Hayek used the phrase “investment in working capital” in the sense of what nowadays would be called operating expenditure. It does not necessarily mean “investment in net working capital” (i.e. the cash buffer between receipts and expenditures) although increasing operating expenditure may very well imply that an increase in net working capital is needed since expenses on wages and raw materials would increase. (Hayek, [1939] 2012, pp. 215–217; Kaldor [1942] 2012, p. 302). Professor Klausinger has interestingly commented that “in the end the Ricardo effect was salvaged by giving up most of what had distinguished it from alternative explanations of the upper turning point” (ibid., p. 22; cf. Blaug, 1997, p. 526). Indeed, because Hayek now made the increasingly limited availability of credit the “dominating factor” in bringing about the decline of investment, the superior profitability of investing in more labor-intensive methods of production no longer plays that role of the “dominating factor” that Hayek initially had assumed for it ([1939] 2012, p. 212).
Hayek himself did not admit defeat ([1942b] 2012). His stubborn resistance comes from relying on another argument he brings to the table:Hayek, in “The Ricardo Effect” ([1942a] 2012), interweaves the “scarcity of money capital” argument (based on changing the assumption towards an upwards sloping supply curve of credit” with the “scarcity of real capital” argument. As does Kaldor ([1942] 2012), I treat them separately.Investment must also be constrained because of the scarcity of real capital. An individual firm may be so lucky that the machine it wants to acquire stands “waiting in the shops,” but what “might be true for any one firm [...] will not be true when all firms are simultaneously in the same position” (ibid., p. 278).This argument was probably directed against called Kaldor’s “representative firm subterfuge” (Desai, 1991, p. 67; cf. Kaldor, 1939, p. 44). Hayek uses the limited availability of real capital as evidence that “additional equipment and still more the output produced by it will be available only after considerable delay. And in the interval till this output is available profits which might have been made by quicker methods will be lost and ought to be counted as part of the cost of the production for the most distant future” (ibid.). Besides arguing that realizing profits in the near future will take precedence, Hayek also argues that the the decline of investment comes about for two other reasons. One is that the price of machinery would go up because of an increasing scarcity of labor in the machine producing industries, as labor is being reallocated to the consumer goods industries. The other is that, in so far as new machines are ordered, these will be the cheaper (less labor-saving) types of machines which can be installed more quickly (ibid., p. 281).
Kaldor responded that a rise in prices of machines has nothing to do with what Hayek is trying to prove. A rise in the price of machinery will not lead to a decline in investment from the consumer goods industries:
[Hayek] confuses influences coming from the side of demand with influences coming from the side of supply. If the price of machinery rises, the demand for machines will be less than if it did not rise. But the price of machinery has only risen, on his assumptions, because demand has risen; how does this explain then the emergence of unemployment [in the machine producing industries]? His business is to prove that demand will fall; not that a rise in demand will be checked by a rise in price. ([1942] 2012, p. 307, footnote omitted; cf. Wilson, 1940, p. 176)
There is one part of Hayek’s main thesis that Kaldor cannot put aside completely. This is that entrepreneurs in the consumer goods industries will prefer cheaper but less labor-saving machinery (which can be installed more quickly) over more labor-saving equipment (which will take longer to put in place). But to Kaldor even this does not prove much:
It is only if the entrepreneur expects higher prices for his products in the near future than in the more distant future that it might become more profitable to install the machine with the shorter construction period, even though the rate of interest is the same [...] assuming that the latter is the case, what does it prove? […] Professor Hayek has taken on himself to prove that this will cause a fall in demand for capital goods, and thus unemployment in the capital goods trades; and to the latter contention the argument contributes nothing at all.” ([1942] 2012, p. 308)Hayek did not use the phrase “construction period” in his theory of the Ricardo Effect. Kaldor’s use of this term, which was used by a number of authors in the 1930’s capital debates, is a good indication that this point has more to do with the capital-theoretic questions that form part of the background of the debate. The idea behind both Hayek’s and Kaldor’s reasoning is the law of roundabout production, i.e that longer construction periods (given “wisely chosen” methods) result in more labor-saving machinery (Hayek, [1941] 2009, p. 77).
2.3 Hayek’s Visualizing Problem
One problem that Hayek himself identified with his theory was that he admitted to “find it difficult to visualise precisely how [the Ricardo effect] will be brought about” (Hayek [1942a] 2012, p. 280). That Hayek did not really have a precise visualization how the Ricardo Effect would occur may also be evident from his description of that effect:
the [Ricardo] effect [...] will be twofold. On the one hand it will cause a tendency to use more labour with existing machinery, by working over-time and double shifts, by using outworn and obsolete machinery, etc. On the other hand, in so far as new machinery is being installed, either by way of replacement or in order to increase capacity, this, so long as real wages remain low compared with the marginal productivity of labour, will be of a less expensive, less labour-saving, and less durable type.” ([1939] 2012, p. 219)
In fact we find here three different effects. The first is increased capital utilization (“over-time and double shifts”) The second is an asset replacement delay (“using outworn and obsolete machinery”). Only the third is the narrow interpretation of the Ricardo Effect as factor substitution (changing to “less labour-saving” machinery). There is not one concrete manifestation of the Ricardo Effect. The common aspect is simply that they all help produce output in the near future at the expense of output in the distant future. A Ricardo Effect could thus be defined more broadly than just a decline of investment on the part of the consumer goods industries. In Hayek’s intertemporal framework a Ricardo Effect can simply mean any shift of resources, a “redistribution of production factors in time as a consequence of a change in the rate of profit” (Birner, 1999, p. 805). This may also suggest that the thesis of the decline of investment on part of the consumer goods industries might only have been an initial rough sketch to visualize what is going on during the latter half of the upswing. In other words, that it is an attempt to concretely visualize a more abstract thesis behind it, namely that towards the end of the upswing resources are shifted towards near future output.
What might Hayek’s visualizing problem be? A clue lies in section 7 of Profits, Interest and Investment ([1939] 2012, pp. 223–226) in which Hayek raises problems with his own visualizing tool, the stages-of-production concept. It involves the capital-theoretic question of combining two different points of view (cf. Birner, 1999, p. 805). On the one hand there is the viewpoint of the Austrian theory of capital, which is intertemporal. It makes a “longitudinal section” of the economy. It considers what happens over a stretch of time and looks upon production as going on in stages through time. On the other hand there is the view of an economy as a dichotomy of a consumer goods industry and a machine producing industry. It is a viewpoint often encountered in the theory of the Ricardo Effect, and it is usually considered a “cross section” viewpoint of production. It considers what happens at a moment or a single interval of time (Wicksell, 1934, pp. 236–237; cf. Garrison, 2001, p. 47; cf. White, 2007, p. xxiv).
Hayek makes use of both the cross-sectional and the intertemporal viewpoints, although as an Austrian capital theoretician, it seems to me, he is principally thinking in intertemporal terms. Therefore Hayek has to translate the meaning of the “lengthening and shortening of roundabout production”—which is going on in multiple “stages”—into the cross-sectional scheme of a division of just two “industries.” When we lay the intertemporal stages-of-production concept over the cross-sectional concept, we can say that the the machine producing industries is the preceding stage of the consumer goods industries, while the consumer goods industries is the following stage. The words “stage” and “industry” seem to have roughly the same meaning.
There is a complication, however, in laying the stages-of-production concept over the cross-sectional scheme of two industries. The consumer goods industry is the last stage; the machine producing industries comprise the one before that. But which industry is the preceding stage of the machine producing industries? The straight answer is that the machine producing industries are their own suppliers of capital goods—the industries are their own preceding stage. This phenomenon was called the “circularity” of the “partial self-reproduction of real capital” in the 1930’s capital debates (Kaldor, 1937; Eucken, 1940). In this lies Hayek’s visualization problem. The complication is the question how to fit such a “circularity” into the linear stages-of-production concept (Hayek, [1935] 2012, pp. 224–225).
Hayek recognizes this difficulty, but he also avoided exploring in which way he could come to a model that would include such circularities. The only clue he left was a reference to a study by Burchardt (1931) which commenced the German 1930’s capital debates ([1939] 2012, p. 225). This issue of “circularities” was also not drawn into discussion in the debates on Hayek’s theory of the Ricardo Effect in the early 1940’s (Wilson, 1940; Hayek, [1942a] 2012; Kaldor [1942] 2012). Nor has a discussion of its possible significance for “Ricardo Effects” appeared in the secondary literature since then (Lachmann, 1940; Lutz and Lutz, 1951; Gilbert, 1955; O’Driscoll, 1977; Haberler, 1986; Moss and Vaughn, [1986] 2010; Steele, 1988; Hagemann and Trautwein, 1998; Birner, 1999; Gehrke, 2003; Klausinger, 2012).
- POINTS OF DEVELOPMENT OF HAYEK’S THEORY OF THE RICARDO EFFECT In what follows is a list of points on which my development of the theory of the Ricardo Effect originates in Hayek’s theory of the Ricardo Effect. In my development I will deviate at various points from the importance that Hayek gives to certain aspects of his theory, such as his concrete thesis and his conclusions. I believe I can still call my theory a “development of the theory of the Ricardo Effect,” since almost all of these deviations are the result of re-evaluating or developing the ideas and concepts of Hayek’s original theory of the Ricardo Effect.
(1) I follow Hayek in believing that “a rate of profit rather than a rate of interest is the dominating factor in this connection” (ibid., p. 212). It means, I think, that the lead role in bringing about the crisis, at least in the second half of the upswing, lies not with capitalists that have malinvested their expenditure on fixed capital because of misguidance by the rate of interest (Hayek [1935], 2008, p. 272). On the contrary, it has to do with capitalists that unmisguidedly reap profits by decreasing their capital expenditure and increasing their operating expenditure (cf. Kaldor, 1939, p. 64; [1942] 2012, pp. 286–290; cf. Huerta de Soto, 2006, pp. 368–370).This thematic difference perhaps accounts for the fact that Hayek’s theory of the Ricardo Effect is hardly integrated into modern versions of the Austrian Business Cycle Theory (ABCT). Modern versions of ABCT often build on Hayek’s Prices and Production (e.g. Garrison, 2001, p. 11) and are largely occupied by explaining the malinvestment of capital expenditure during the business cycle through analyzing the circumstances of committing capital expenditure (ibid., p. 81).
(2) I will stick to Hayek’s initial assumption of a continuing credit expansion throughout the upswing, which was more or less tied to the rate of profit as the “dominating factor.” I believe Hayek’s ‘retreat,’ by changing his assumptions on the supply of credit during the upswing in “The Ricardo Effect” ([1942a] 2012), and so giving up most of what was original in his approach in Profits, Interest and Investment ([1939] 2012), has everything to do with his sticking to his concrete thesis that during the upswing the capitalists of the consumer goods industries decrease their capital expenditure.
(3) In terms of understanding the structure of production through theoretical concepts, section 7 of Profits, Interest and Investment ([1939] 2008, pp. 223–226) offers some very interesting suggestions for developing the “stages of production” concept from Prices and Production ([1935] 2008, pp. 223–252). Hayek left here much room for development, especially in incorporating the role of fixed capital and “circularities” into the concept of the stages of production.
(4) Comparing Hayek’s theory of the Ricardo effect ([1939] 2012; [1942a] 2012), with Mises’s chapter on the business cycle in Human Action ([1949] 1998, pp. 535–583), there is an interesting difference between these two originators of the Austrian business cycle theory. To Mises, the “very well known fact” is that the machine producing industries are “overloaded with orders” when the business cycle is approaching the upper turning point (ibid., p. 583). This ‘stylized fact’ suggests that only in the downswing the machine producing industries will start to experience idle capacity. Hayek’s theory of the Ricardo Effect, however, posits the thesis that somewhere half-way the upswing of the business cycle, the consumer goods industries increasingly do not replace their worn-out machines and do not invest in modernizing their machinery ([1939] 2012, p. 219; [1942a] 2012, pp. 267–268). This suggests that the ‘stylized fact’ should be that there is already a fair amount of idle capacity in the machine producing industries when the business cycle approaches the upper turning point.
The interesting difference between Mises and Hayek is thus a difference in what is (according to Mises) and what theoretically ought to be (according to Hayek) the ‘stylized fact’ concerning the level of idleness in the machine producing industries as the business cycle approaches the upper turning point. I believe Mises is right about his stylized fact, which partly accounts for the main deviations between Hayek’s theory of the Ricardo Effect and my development of it. However, the connection with Hayek’s original theory is that I believe that Hayek was right in principle about the occurrence of a Ricardo Effect.
(5) Hayek relies in his theory of the Ricardo Effect on the wage rate as the major element in the profit mechanism, for capitalists will compare the “profit earned on the turnover of any amount of labor” invested for different periods ([1939] 2012, p. 215). The role of the wage rate seems therefore crucial in the theory of the Ricardo Effect, as Hayek clearly says that the “substance [of the Ricardo Effect] is contained in the familiar Ricardian proposition that a rise in wages will encourage capitalists to substitute machinery for labor and vice versa” (ibid.). However, Hayek subsequently also argued that “it is through this [Ricardo] effect that the scarcity of real capital will make itself ultimately felt” ([1942a] 2012, p. 259). In my development of the theory of the Ricardo Effect, I will deviate from Hayek’s original theory by taking the profit earned on the turnover of versatile fixed capital as the major element determining “the rate of profit.” This is also consistent with point (3) above.
(6) In his theory of the Ricardo Effect, Hayek argues that a shift from capital expenditure towards operating expenditure takes place ([1939] 2012, p. 219; [1942a] 2012, p. 262; [1946] 2009, p. 149). Hayek’s suggestion that this increase in operating expenditure would occur “at a point somewhere half-way through a cyclical upswing” (Hayek [1939] 2012, p. 217) seems almost identical to Keynes’s finding that “the characteristic secondary phase of a credit cycle” was “due to the growth of investment in working capital” (Keynes, 1930, p. 252). Much earlier Lord Overstone, a leading member of the Currency School, had pointed towards widespread “overtrading” ([1857] 1972, p. 31)—pushing operating expenditure to or beyond the sustainable margin—in the excited last phase before the upper turning point. Now, whether increasing operating expenditure is the result of a shift from capital expenditure or not, it remains a ‘stylized fact’ of cyclical upswings that workers are employed in “over-time and double shifts.” Hayek’s theory of the Ricardo Effect can be seen as an attempt to explore this aspect of the business cycle, and its possible link to overconsumption (cf. Salerno, 2012). Although I will attempt to demonstrate a slightly different thesis than Hayek’s, the task remains to explain this increase in operating expenditure.
(7) In discussing the role of rising costs, and especially rising prices of raw materials, during the upswing, Hayek expands the model of a “crude dichotomy of industry into consumers’ goods industries and capital goods industries” into a trichotomy that also includes a raw materials industry ([1939] 2012, pp. 229–230). With Hayek this trichotomy remains a short verbal sketch, which I will attempt to develop.
- THE STRUCTURE OF PRODUCTION 4.1 The Difficulties of the Stages-of-Production Model
In Prices and Production ([1935] 2008) Hayek introduced his famous triangles of the structure of production, what he called the “stages of production.” What is important to mention about his triangles in that book, is that the first triangle he provides is a longitudinal or intertemporal triangle, reproduced as Figure 1 below (ibid., p. 228). The second to sixth figures of triangles (such as Figure 2 below) are cross-sections of the first figure (ibid., pp. 232–247).
Figures 1 and 2
The difference between them is that Hayek’s cross-sectional triangles deal with the current distribution of inputs (and spending) among stages that are performed simultaneously “in a given period” ([1935] 2008, p. 232). A cross-section can be likened to a snapshot of a situation at a moment in time. The intertemporal understanding of the economic process follows from imagining the sequence of such cross-sections, much like a moving picture is actually a sequence of snapshots. Hayek moves from one cross-section to another in order to portray the changes in the structure of production due to either increased (voluntary) savings or (fiduciary) credit expansion (ibid., pp. 232–247). However, only the first figure is really intertemporal in it self (or “longitudinal,” as Wicksell would say). It not only represents current output of consumer goods and intermediate goods on the one hand, it also serves as a picture of future output due to the present allocation of resources. Hayek’s particular intertemporal triangle deals with the output due to the average length of production in a “stationary society” (ibid., p. 229). In a stationary society future output of consumer goods and intermediate goods is as high as the current output of those goods. The intertemporal function of this triangle may seem somewhat purposeless therefore, because there are no intertemporal differences of output in a stationary society. The point is that if such a stationary society would be transformed into another stationary society with a longer average period of production, then after a period of transition in which the output of consumer goods is lowered, the current production of both intermediate goods and consumer goods will have increased. During the “traverse” between two stationary societies, some stages are partly abandoned, in order to perform stages not previously engaged in. After the traverse, the intertemporal triangle has become wider and longer.
As mentioned before, in Profits, Interest and Investment ([1939] 2012) Hayek reflects on the question of how the demand for capital goods plays out in the “structure of capitalistic production.” He argues that “a crude dichotomy of industry into consumers’ goods industries and capital goods industries is wholly insufficient to reproduce the essential features of the complicated interdependency between the various industries in real life” (ibid., p. 224). Certainly, this dismissal of the “crude dichotomy” is rather incompatible with the fact that he uses such a dichotomy in various parts of his theory of the Ricardo Effect. A telling example is Hayek employing a verbal model of “integrated firms” which consist of two departments; one department that produces commodities, another department that produces machines ([1942a] 2012, pp. 279–280).The (Marxian) dichotomy of consumers goods industries and machine producing industries was called the Abteilungsschemen in German (Eucken, 1940, p. 118), which literally stands for “departmental scheme” (Nurkse, 1935). Hayek also extensively uses the closely related distinction between “expenditure on wages (or investment in ‘circulating capital’) and expenditure on machinery (investment in ‘fixed capital’)” (ibid., p. 262).
Besides commenting on the insufficiency of the “crude dichotomy,” Hayek also addresses the insufficiencies of his own stages-of-production model, which consists of more steps in the production process than just two.Hayek does not make explicit whether his doubts concern the longitudinal or the cross-sectional stages-of-production concept. I believe it refers to the crosssectional stages-of-production concept. To Hayek, the stages-of-production model “is not quite adequate for the purpose” either ([1939] 2012, p. 224). He points out that it “gives the impression of a simple linearity of the dependency of the various stages of production which does not apply in a world where durable goods are the most important form of capital” (ibid.). This is because, as he admits, it was based on the “assumption that all capital used was of the nature of circulating capital” (ibid., p. 224). Hayek then speculates on a modification of his stages-of-production concept, by designating some stages as responsible for producing fixed capital:
If we designate the production of consumers’ goods as stage I we can then classify the various industries which directly supply the consumers’ goods industries with capital goods of various kinds as stages II, III, IV, etc., according to the more or less “capitalistic” character of the equipment which they supply. Stage II would supply the consumers’ goods industries with the least capitalistic type of requirements, such as the raw materials and their simplest tools. Stage III would supply them with equipment of little durability and machinery of the least automatic type. Stage IV would supply a somewhat more capitalistic (more durable or more labour-saving) type of machinery, and so on to stage V, VI, etc., in ascending order. (ibid., p. 224)
Through this modification, a machine from stage IV could be delivered immediately to the consumer goods producers at stage I. That machine does not have to pass a number of stages in between. It is in the nature of circulating capital that it often does pass a number of stages when it is processed from raw materials into consumer goods. In this respect, Hayek certainly revises his expository device of Prices and Production ([1935] 2008).
But Hayek still feels that such an adaption of the stages-of-production concept “gives an undue impression of linearity of these relationships while in fact they may in many respects be rather circular in character” (ibid., pp. 224–225). What Hayek means must be something like this: The more labor-saving equipment provided by stage IV would be used to help produce the “simplest tools” that will be put out by stage II, while at the same time the “simplest tools” provided by stage II could also help to produce the “more labor-saving equipment” at stage IV. So for fixed capital, it is not only the case that a number of stages could be passed over when it travels from a higher to a lower stage. Its services may also be “put back” to a higher stage (Eucken, 1937, p. 541 et passim). This phenomenon of “circularities”The phenomenon of “circularities” has also been described as “whirlpools” (Dorfman, Samuelson, and Solow, [1958] 1986, p. 205) and recently as “looping” (Cachanosky and Lewin, 2016, p. 17). While Dorfman et al. and Cachanosky and Lewin seem to use these phenomena against the determinability of a structure of production, Lowe (1976, p. 34) uses it as evidence for such a determinability. in the structure of production played an important role in the 1930s capital debates as it formed a challenging aspect to the ‘Austrian’ stages-of-production concept (Kaldor, 1937). Hayek alludes to this phenomenon by referring in a footnote to a study by Burchardt that started the 1930s capital debates in Germany (ibid., 225). Hayek even notes Burchardt as having given “the most fruitful of all the recent criticisms of the ‘Austrian’ theory of capital” (ibid.).
This is the point in the original theory of the Ricardo Effect where Hayek practically invites it to be developed. Hayek offers a few pages of doubts and ideas about the stages-of-production model, but it does not lead up to a systematically elaborated improvement over Prices and Production ([1935] 2008). In what follows I will treat the relation of cross-sections to intertemporal output first, before addressing the “circular” relationships in the cross-section itself.
4.2 Sequences of Cross-Sections to Picture Intertemporal Changes
The longitudinal and cross-sectional aspects of the Hayekian triangle may easily get confused because the first figure on the one hand, and second to sixth figures on the other hand, are all triangular. In fact, Professor Garrison argues that “the Hayekian triangle has a double interpretation” (2001, p. 47). This double interpretation has resulted from fusing the two different kinds of triangles into one. For the further discussion, I propose to disentangle these purposes by keeping the cross-sectional and longitudinal aspects apart by not fusing them into a single stages-of-production concept. As far as the question of understanding the relationship between the intertemporal aspects of production and the interdependencies of industries, I find it useful to employ a cross-sectional model (not necessarily a triangular model) that pictures the current distribution of input, and then think of the future consequences of that current distribution in order to draw a subsequent cross-section.
As a simple cross-section of an economy, we can take Professor Garrison's production possibilities frontier or “PPF.” The PPF depicts the current distribution between consumption-spending C and investment-spending I, as depicted in the three PPFs in Figure 3. Therefore, it could be said that “a crude dichotomy of industry into consumers’ goods industries and capital goods industries” is implied in Professor Garrison’s PPF, simply because it crudely divides the economies’ output into consumer goods and capital goods (ibid., p. 46). The underlying thought of Professor Garrison’s PPF is intertemporal, because “the economy grows to the extent that it uses its resources to the production of capital goods rather than the production of consumer goods” (ibid., p. 41). However, the PPF does not depict future output or future output capacity. But if we imagine a sequence of PPFs we could say that any PPF at time t is the result of the distribution between consumption-spending (C) and investment-spending (I) along the PPF at time t-1.
Such a sequence is actually depicted in Figure 3: Suppose a movement along the PPF towards more investment (a to b) takes place at t=1. This would imply that the economy has more resources at the next cross-section at t=2. In other words, it will have more resources at t=2 as the result of more resources being devoted to producing capital goods rather than consumer goods at t=1. The PPF shifts outwards from t=1 to t=2 (the dotted line at t=2 representing the PPF at t=1). Then at t=2 a new allocation would have to be made among consumption-spending and investment-spending. Suppose that this choice involves an allocation of such a small amount of investment-spending that the capital stock of the economy cannot be maintained intact (from b’ to a’). This will mean that the PPF will shift inwards from t=2 to t=3.
Quarterly Journal of Austrian Economics 20, no. 3 (Fall 2017)Abstract: Shawn Ritenour provides a review of my two-volume book Money, Banking, and the Business Cycle in the Winter 2016 issue of this journal. In his review, he provides a number of criticisms of the book and offers some compliments of the book as well. While I appreciate the compliments, most of the criticisms are not valid. In this response, I explain why it is that more money in the economy leads to more profits. I also show the difference between making a distinction between the rate of profit and the interest rate and saying they are independent of each other. Furthermore, I discuss the effect of changes in interest rates versus changes in the rate of profits. I discuss criticisms of Objectivist philosophy as well.
KEYWORDS: Austrian school, business cycle, net consumption-net investment theory of profits, profit, interest, ObjectivismJEL CLASSIFICATION: E14, E32
Quarterly Journal of Austrian Economics 20, no. 3 (Fall 2017)Abstract: An open question in the Austrian business cycle theory is how labor markets across the structure of production react to broader changes in the economy. Particularly, how do labor market conditions in industries at different stages of production respond to changes in monetary policy? This paper investigates the issue by analyzing the response of employment and earnings to monetary policy shocks for ten different sectors of the economy. The results show that labor markets for each sector respond to monetary policy primarily through changes in employment rather than changes in earnings, and that there are distinct differences in the magnitude and timing of employment responses across sectors. Furthermore, these differences in sector-specific responses can be grouped according to the general stage of production that a sector is associated with.
KEYWORDS: Austrian school, business cycle, monetary policy, employment, compensationJEL CLASSIFICATION: B53, E32, E52, J2, J3
Journal of Libertarian Studies 15, no. 3 (Summer 2001) And the taxpayer, not content with thus ruining political science, added insult to injury by damning all its chief ornaments as thieves, and by swearing that he would never let them rook him again. His bellow was now for the most rigid economy, and he swore that he would have it if the heavens fell. There was no holding him while the fit was on him. In many American cities, public expenditures were actually reduced. — H.L. MenckenH.L. Mencken, “What is Going on in the World,” American Mercury 30, no. 119 (November 1933), pp. 259–60.
David Beito did a great service for the scholarship of liberty and American history with his rediscovery of the Great Depression-era tax resistance movement.David T. Beito, Taxpayers in Revolt: Tax Resistance During the Great Depression (Chapel Hill: University of North Carolina Press, 1989). While it would be logical to assume that, during the depression, people simply could not pay their taxes, Beito provides evidence that the vast majority of tax resisters could have paid their taxes but refused to do so. Further, his evidence on the occupations of the members of tax resistance organizations makes clear that this movement was not just made up of wealthy opportunists refusing to pay taxes. He uncovered evidence of widespread opposition to property taxes across America. However, the anti-tax rebellion declined as quickly as it started, a demise that he attrib-utes to a lack of a “focused ideological program” that could capture the popular anti-tax sentiment of the time.Beito, Taxpayers in Revolt, p. 164. Thus, Beito concludes, this tax resistance movement was a failure.Beito, Taxpayers in Revolt, pp. 160–64. On the dust jacket, the publisher notes that the tax resisters “failed ... to offer clear and persuasive pro-posals outlining specific services that could be reduced or eliminated. Their lack of a genuine political program, Beito argues, led to the downfall of a surprisingly potent and popular rebellion.” While his contribution has been praised, questions have been raised concerning Beito’s explanation for the demise of the tax revolt.For example, Mark Leff, in his review of Beito’s book, argued that Beito’s “evidence comes up short” when he tries to explain the precipitous decline in tax resistance after 1933 on a lack of a systematic ideological program. See Mark Leff, American Historical Review 95, no. 5 (December 1990), pp. 1648–49.
In this paper, we argue that the anti-tax movement was a genuine success, and that this success is the reason the revolt ended.This tax revolt was non-violent, unlike previous tax revolts including the American Revolution, the Whiskey Rebellion, and the Civil War. Also, it was far less spectacular than other events of the time, such as the stock market crash, Prohibition, and Roosevelt’s New Deal. This success took two major forms. The first and most obvious was the tax limitation movement, which provided the political pressure to cut taxes and establish limitations on property tax rates. The second, which was both more important and far less obvious, was the passage of the Twenty-first Amendment, which repealed alcohol prohibition (hereafter, Repeal). Under intense political pressure from the tax revolt, politicians supported Repeal in order to provide federal, state, and local government with increased revenues to offset cuts in property taxes while simultaneously providing a drastic decrease in the price of alcohol, and, in effect, granting the American public a gigantic tax cut.The following analysis is based on the initial findings in Chetley Dale Weise, “The Political Economy of Prohibition and Repeal: Ideology, Political Self-Interest, and Information Control” (master’s thesis, Auburn University, 1998).
These policy victories mark the end of the revolt because the primary goals of the movement had been achieved. How else would one explain the rather sudden demise of a movement that consisted of local organizations that were not connected by a national network? The timing of these events supports our hypothesis that the revolt was a success, and that Repeal, which affected the entire nation, was a pivotal event for the tax resistance movement.
The Rise and Fall of Tax Resistance The obvious reason for the rise of tax resistance was that the burden of taxation increased greatly with the onset of the Great Depression. Most Americans had experienced the effects of a relatively good tax policy during the 1920s, with federal income tax rates cut by more than half for all income brackets. The economy expanded during the “roaring ’20s” in response to these tax cuts.Robert B. Ekelund, Jr. and Mark Thornton, “Schumpeterian Analysis, Supply-Side Economics, and Macroeconomic Policy in the 1920s,” Review of Social Economy 44, no. 3 (December 1986), pp. 221–37. The Great Depression brought an end to this growth, and replaced it with record levels of unemployment, mammoth losses of wealth, and a slew of government policies designed to reduce production and sustain high prices.Murray N. Rothbard, America’s Great Depression, 3rd ed. (Kansas City: Sheed and Ward, 1975).
The most burdensome tax for most Americans was the property tax. Property taxes required taxpayers to make an explicit payment of a significant amount, a payment the taxpayer could not evade without losing what was often his most significant piece of wealth and property.
Property taxes had increased significantly in the decade prior to the Great Depression. City government had grown enormously in size, scope, and debt during the 1920s, and revenues for city governments had become more dependent on property taxes. According to Beito, “throughout the 1920s, the general property tax accounted for over 90 percent of taxes levied by all cities over 30,000 in population.”Beito, Taxpayers in Revolt, p. 1. The primary reason for this dependence was that alcohol revenue from sales taxes and licenses had “dried up” due to prohibition.
Higher property taxes and a narrower tax base were largely tolerated during the 1920s because economic growth meant that property tax revenue could be increased via higher property values and assessments rather than higher tax rates. Taxpayers were more willing and able to pay rising property tax bills during the 1920s because wages, incomes, and the stock market were rising along with the value of homes and businesses.
The stock market crash and the Great Depression changed everything. The real burden of taxes on the American people increased significantly. Even if tax rates remained the same, tax burdens increased because the market value of property fell relative to assessed values. The real burden also increased because personal income was falling relative to property tax bills. Finally, the real burden of property taxes rose because price deflation increased the purchasing power of the dollar.
Beito described this crushing burden by comparing total tax payments as a percentage of income:
As a percentage of the national income, perhaps the most pertinent measure of the burden’s impact, taxes nearly doubled from 11.6 percent in 1929 to 21.1 in 1932. In just three years, the tax load on the American people increased more than it had in the 1920s. Not even during World War I had taxes ever taken such a large percentage of the national income. Taxes at the local level more than doubled, rising from 5.4 percent of the national income in 1929 to an unheard of 11.7 percent in 1932. Surging even faster, state taxes went from 1.9 percent in 1929 to 4.6 in 1932. At the same time, federal tax collections stayed relatively constant, inching up from 4.2 percent in 1929 to 4.7 in 1932.Beito, Taxpayers in Revolt, p. 6.
Clearly, the tax burden rose substantially, and most of the increase occurred at the state and local level. As the main weapon in the government’s arsenal, the property tax naturally became the focal point of the tax resistance movement.
With the tax burden, tax delinquency, and bankruptcy rising, the country became increasingly ripe for a tax revolt. Tax delinquency increased from its normal rate of 10 percent to more than 30 percent,Fred Rogers Fairchild, “The Problem of Tax Delinquency,” American Economic Review (March 1934), pp. 140–50. According to Fairchild, “that tax delinquency has at present reached the proportions of a major problem in the finances of many cities, counties, and towns is realized in a general way by all well-informed persons” (p. 140). Fairchild goes on to describe statistically the giant increases in the burden of government by noting that the “total of all taxes in the United States absorbed 7.2 per cent of the total income of the people in 1890; in 1930 it took 14.4 per cent, exactly twice as large a share of national income” (p. 147). and tax protest organizations formed spontaneously in rural regions, in response to attempts to sell the property of farmers to meet their tax obligations. Likewise, taxpayer leagues formed in urban areas to protest high taxes and property foreclosures. Estimates placed the number of such organizations at between 3,000 and 4,000 nationwide.Weise, “The Political Economy of Prohibition and Repeal,” p. 62.
Beito attributes the failure of tax resistance to two problems: lack of a well-developed ideological platform, and the lack of a professional organization. Indeed, the lack of an effective national organization that might control and manage tax resistance led local groups to organize along different lines, develop different strategies, and employ different tactics. However, despite these differences, thousands of local tax resistance groups disbanded at the same time as Repeal and the passage of numerous tax limitation statutes. The timing of these events clearly supports our conclusion that the movement was, indeed, a success.
Prohibition and Public Finance The Repeal of Prohibition provided several significant victories to the tax resistance movement. Repeal caused the price of alcohol to plummet and allowed local, state, and federal governments to reinstate alcohol taxes and increase government revenues. State and local governments also gained additional revenue via licensing fees and other alcohol-related charges, and federal alcohol taxes freed up additional money that could be provided to state and city governments through grants, public works, and other assistance. This revenue helped offset revenue lost from property tax cuts and tax limitation statutes. Additionally, Repeal also reduced spending on the enforcement of prohibition, reduced political corruption, and greatly alleviated the aggregate burden of crime.Mark Thornton, “Alcohol Prohibition was a Failure,” Policy Analysis no. 157 (Washington, D.C.: Cato Institute, 1991).
Prior to the income tax, tariffs and alcohol taxes provided the bulk of federal government revenues. From 1870 to 1920, customs and liquor taxes provided nearly 80 percent of all federal revenue. When the income tax amendment was passed in 1913, its revenue-raising ability was quickly realized. Revenues in 1917 were nearly three times those of 1916. Congress amended the tax in October of 1917, and revenues increased enormously in 1918, just as they had estimated. The income tax therefore provided a revenue substitute that permitted passage of the Eighteenth Amendment and the loss of alcohol tax revenues.Donald Boudreaux and A.C. Pritchard, “The Price of Prohibition,” Arizona Law Review 36 (Spring 1994), p. 3.
However, the Great Depression placed a severe financial constraint on Congress by reducing income tax revenue by 60 percent between 1930 and 1933. The search for alternative revenue led to Franklin Roosevelt’s conversion from a “dry” to a “wet,” and led to the Democratic Party’s endorsement of Repeal in their 1932 platform to provide “a proper and needed revenue.”Boudreaux and Pritchard, “The Price of Prohibition,” pp. 6–7.
Prohibition also wiped out alcohol sales tax and licensing revenues going to city, county, and state governments. Repeal re-established these revenues, permitting property taxes to be reduced. Repeal, therefore, brought victory to the tax resistance movement, whose primary aim was to reduce the burden of the property tax. Evidence from four major cities demonstrates that property taxes declined in overall importance after 1933. Property taxes decreased as a percentage of the overall city revenue from 67 percent during 1930–1932 to only 61 percent during 1933–1940—a shift in the structure of local government revenue and a victory for the tax resistance movement.
The most direct channel for increased revenues for local governments was the sales and excise taxes on alcohol and license fees from alcohol vendors. While most non-property income sources were stagnant throughout the Great Depression, business taxes were an important exception, growing an average 900 percent in five large cities between 1933 and 1940. This category is where most of the alcohol tax and license fee revenues accrued.Bruce Allen Hardy, “American Privatism and the Urban Fiscal Crisis of the Interwar Years: A Financial Study of the Cities of New York, Chicago, Philadelphia, Detroit, and Boston, 1915–1945” (Ph.D. diss., Wayne State University, 1977), p. 407. The Bureau of the Census noted that cities were “experimenting” with licensing to raise revenue, and that liquor licensing was the main target for enhanced revenues, increasing from zero in 1932 to more than $40 million in 1936, to $70 million by the end of the decade.United States Bureau of the Census, Financial Statistics of Cities over 100,000 Population: 1937 (Washington, D.C.: U.S. Government Printing Office, 1940), p. 21. See also Weise, “The Political Economy of Prohibition and Repeal,” p. 87.
The second channel by which alcohol revenues displaced property taxes was state government. By 1938, state governments received more than $250 million in alcohol tax revenue, and more than $60 million from state liquor monopolies.United States Bureau of the Census, Historical Statistics of the United States: Colonial Times to 1970, Part 2 (Washington, D.C.: U.S. Government Printing Office, 1975), p. 1130. Increased state revenues via alcohol sales tax collections permitted state governments to return money to city governments in the form of aid and grants. For example, alcohol tax revenue in Illinois was more than $4 million in the first full year after Repeal, and climbed to $12 million by the end of the decade. Between 1934 and 1938, Chicago received a 700% increase in state aid.Hardy, “American Privatism,” p. 407.
The third channel for alcohol-related tax revenue was the federal government. According to Hardy, there was recognition that “city governments could not carry the entire burden of unemployment when it was a national problem. Financial assistance would have to come from Washington.”Hardy, “American Privatism,” p. 360. Federal alcohol tax revenue went from zero before Repeal to $259 million in 1934, to $624 million by the end of the decade.Tax Institute, Tax Yields: 1940 (Philadelphia: College Offset Press, 1941), p. 36. This increased revenue allowed the federal government to play a greatly enhanced role in local public finance.
Normally, tax redistribution would not be considered a tax reform victory, but, in this case, Repeal produced a clear defeat for taxes and government authority. Property taxes were cut and alcohol consumers received what amounted to a substantial tax cut equal to more than 2.5 percent of Gross Domestic Product.Normally, falling prices would not be considered a tax cut. However, because the fall in price from black-market levels to “sin tax” levels was entirely the result of a change in government policy, it can be viewed as a type of tax cut.
The total price or cost of alcohol during Prohibition was higher than legal alcohol in three respects. First, the basic monetary price was as much as 500 percent higher than either before or after Prohibition.Mark Thornton, The Economics of Prohibition (Salt Lake City: University of Utah Press, 1991), p. 102. Alcohol products were also more costly because of the decrease in quality of products produced and sold in black markets as compared to those in free markets.Mark Thornton, “The Potency of Illegal Drugs,” Journal of Drug Issues 28, no. 3 (Summer 1998), pp. 725–40. Finally, illegal alcohol products were more costly because of the reduced information and increased transaction costs typically associated with black markets.Mark Thornton, “Perfect Drug Legalization,” in How to Legalize Drugs: Public Health, Social Science, and Civil Liberties Perspectives, ed. Jefferson Fish (Northvale, N.J.: Jason Aronson, 1998), pp. 638–60.
Even if we ignore quality, information, and transactions costs, the Repeal of Prohibition, along with a 100 percent tax on alcohol products, would still leave the American alcohol consumer better off. In an economy of approximately $100 billion and an alcohol products industry of approximately $5 billion, a reduction in prices in excess of 50 percent amounts to a substantial tax cut for the country in general, and for alcohol-consuming households in particular. Surely, this must have been one of the main reasons for Franklin Roosevelt’s popularity.Tax resistance groups were naturally reluctant to take an official position on alcohol policy for fear of dividing their membership and reducing their effectiveness.
Tax Limitation: The Legacy of Resistance The success of efforts to establish property tax limitation policies was another important victory for the tax revolt that had a lasting impact. Arthur O’Sullivan, Terri Sexton, and Steven Sheffrin speak highly of “organized tax-resistance movements throughout the country” during the Great Depression, noting that
The tax revolts of recent years pale in comparison to the activities that took place during the Great Depression. In 1932 and 1933 alone, 16 states and numerous localities enacted property tax limitations.Arthur O’Sullivan, Terri A. Sexton, and Steven M. Sheffrin, Property Taxes and Tax Revolts: The Legacy of Proposition 13 (Cambridge: Cambridge University Press, 1995), p. 1.
For these experts on tax revolts, tax limitations were the successful outcome of the tax resistance movement during the Great Depression. The timing of these successes helps explain why the movement ended.
Experts at the time also recognized the connection between the property tax revolt and tax limitations as “common knowledge.” Economist and public finance expert Paul Wueller put it succinctly:
Complaints regarding the “burden” of the realty tax have multiplied manifold. Legislators from coast to coast responded to delinquencies and clamor by providing for over-all realty tax limits.Paul H. Wueller, “Real Property as a Tax and Reimbursement Base during the Depression,” in Property Taxes (New York: Tax Policy League, 1940), p. 21.
Property taxes were further reduced by the adoption of homestead exemptions and reductions in property assessments such that overall local real estate taxes declined from $4,337 million in 1929 to $3,744 million in 1934, and that state realty taxes declined from 27 percent of total revenue in 1929, to 19 percent in 1932, to only 7 percent in 1937.Wueller, “Real Property as a Tax and Reimbursement Base during the Depression,” pp. 21–40. Tax limitations were clearly a success for the tax resistance movement. They greatly reduced property taxes, gave greater security of property rights to homeowners, and reduced overall revenues to state and local governments.
However, these victories were not without their drawbacks, as local governments began to develop new sources of revenue such as the sales tax. Another major drawback of tax limitation was that local governments became more dependent on the state and federal government. Donovan F. Emch, a Great Depression-era expert on local public finance, described these local governments as “but humble mendicants daily seeking succor at the hands of the state.”Donovan F. Emch, “The Effects of Tax Limitation in Ohio,” in Property Taxes (New York: Tax Policy League, 1940), p. 69.
One modern-day expert examines the negative implications of tax limitation at greater length. Glenn Fisher cautions that constraining local government but leaving state and federal government unconstrained only encourages local governments to become more dependent on state and federal governments for resources. As a result, overall government in America has become more centralized and powerful.Glenn W. Fisher, The Worst Tax? A History of the Property Tax in America (Lawrence: University of Kansas Press, 1996).
Therefore, while successful in its narrow mission to reduce and control property taxes, the tax revolt movement did fall short of reducing and controlling taxation in the long run. Here, Beito’s complaint about the lack of a “focused ideological program” rings true. Such a program would have made tax protestors resistant to compromise, steeled them against new taxes, and compelled them to form national organizations capable of more formidably challenging government’s power to tax.
Quarterly Journal of Austrian Economics 20, no. 1 (Spring 2017)
ABSTRACT: The aim of this article is to demonstrate how monetary disorder spawns asset price inflation. This is re-interpreted here according to modern usage as meaning an empowerment of irrational forces in asset markets. The author blends insights from behavioral finance research and from Austrian business cycle theory to develop a hypothesis about how mental flaws of investors become inflamed by monetary influences and how these contribute to episodes of widespread mal-investment. Identifying two types of asset price inflation—boom type and depression type—this article draws on the last century of history to illustrate both through several stages, accompanied by a variable intensity of inflation symptoms in the goods markets.
KEYWORDS: asset price inflation, Austrian business cycle theory, carry trade, hunt for yield, irrational exuberanceJEL CLASSIFICATION: B53, E14, E31, E32, E42, E43, E44, E58, F45, G02, G12, N12, N14
Beyond the behavior of speculators or OPEC—which some consider a cartel, if there is anything we can learn is that the fall in oil prices responds to the forces of supply and demand. On the demand side, lower economic activity throughout the world, specially in China, has lowered the price of oil. Projections by the International Energy Agency show how demand weakened in 2014, although it rebounded in 2016.
However, there is no doubt that the supply side saw the most significant change. There has been much talk about fracking and how this technology—implemented primarily in the United States—has affected the oil supply. Between 2008 and 2014, the US oil supply increased by 76%.
This shock in the supply of oil and the weak demand has accustomed people to low oil prices. In 2016, the average price of a WTI barrel was valued at $43.15. In June 2016, the price was over $90. In just one year, from June 2014 to June 2015, the price of a barrel fell 43%.
The shock in the supply will not last forever: producers have different marginal costs. In the past, high oil prices made new forms of production with greater marginal costs profitable. If prices remain low, some producers could exit the market and there would be a price adjustment. Yet, there are good reasons to think that oil won’t reach the exorbitant prices of early 2014.
The question many are asking is: why hasn’t OPEC acted to keep prices from remaining low? To answer this question, we need to examine whether OPEC is able to manipulate prices.
Is OPEC a Cartel?Economists define a cartel as a group of producers that come together to plot in the market. In other words, a group of producers agree to restrict supply and maintain prices at a certain level, making their incomes greater. However, for this to happen the members of the cartel need to have a dominant position in the market.
Although many economists consider OPEC a cartel, the question becomes difficult to answer when we look at historical data. In their book The Price of Oil, Roberto Aguilera and Marian Radetzki lay out empirical evidence showing that, historically, OPEC has not been able to act as a cartel. OPEC’s policy has always consisted in setting maximum production quotas to keep the supply below a certain level; yet these quotas are rarely followed and OPEC countries generally produce at 94% of their capacity.
On the other hand, OPEC’s market share does not clearly show a dominant position in the market that would allow them to directly influence prices. According to Aguilera and Radetzki, OPEC’s market share has varied between 31% and 56%. Although it might seems like a large share it is not, especially if we compare it to other minerals such as bauxite where there is a supply concentration of 73% to 81%.
OPEC has announced that it hoped to reach an agreement to extend the output cuts of major oil-producing countries. Certainly, the quotas fixed by OPEC have an influence on the price of oil, but this does not make OPEC a cartel. Only the future will tell if OPEC’s measures have any effect on oil prices or if our interpretation that they aren’t able to move prices is true.
Reprinted from Market Trends at Universidad Francisco Marroquin.
Quarterly Journal of Austrian Economics 19, no. 4 (Winter 2016)
Whenever a new book on money and the business cycle from an Austrian perspective is published, the hope is that it will be another monumental contribution setting before the reader the best of monetary and business cycle theory. Alas, while Brian P. Simpson’s Money, Banking, and the Business Cycle includes 509 pages of small dense print stretching over two volumes, such hope is unfounded. While making numerous helpful contributions to our understanding of the economic history of business cycles in the United States, the way Simpson develops his business cycle theory leads to more confusion than clarification. So much so that the work is ultimately disappointing. One should not turn to Money, Banking, and the Business Cycle to learn Austrian business cycle theory. For those looking for a modern, book-length treatment of business cycle theory from an Austrian perspective, Huerta de Soto’s Money, Bank Credit, and Economic Cycles and Roger Garrison’s Time and Money are still preferable.
Quarterly Journal of Austrian Economics 19, no. 4 (Winter 2016)
ABSTRACT: The aim of this article is to examine the impact of shadow banking on credit expansion and the business cycle. I focus on two main functions of the shadow banking system: securitization and collateral-intermediation. The former enables traditional banks to expand their credit activity, while the latter allows the shadow banks to create new money by themselves. Shadow banking shows that non-banking institutions can also conduct credit expansion and generate the business cycle. Thus, the Austrian business cycle theory should be extended to take into account the way in which shadow banking activity changed the conduct of credit expansion.
KEYWORDS: shadow banking, business cycle, credit expansion, Austrian business cycle theory, securitization, collateralization
JEL CLASSIFICATION: B53, E32, E51, G21, G23 Published on the Mises Wire
Quarterly Journal of Austrian Economics 19, no. 3 (Fall 2016)ABSTRACT: We develop a simple mathematical version of Garrison’s model. The purpose to develop a mathematical framework is to (1) show how such representation can be used and (2) layout a path for future work that requires a more flexible version of Garrison’s treatment than the graphical exposition. While the graphical model is limited to three dimensions, a mathematical version can include more variables of interest. First, we develop the mathematical framework of Garrison’s treatment. Then we apply it to the cases of increase in savings, secular growth, and the Austrian business cycle theory.
KEYWORDS: business cycle, Austrian School, GarrisonJEL CLASSIFICATION: B53, E32
The Quarterly Journal of Austrian Economics
Vol. 19 | No. 3 | 225–247Fall 2016
A Mathematical Version of Garrison’s ModelNicolás Cachanosky and Alexandre Padilla
Nicolás Cachanosky (ncachano@msudenver.edu) is assistant professor of economics, and Alexandre Padilla (padilale@msudenver.edu) is associate professor of economics, at the Metropolitan State University of Denver. The authors would like to thank the two anonymous referees for their comments, which helped clarify and improve this paper’s core arguments. The usual caveats apply.
ABSTRACT: We develop a simple mathematical version of Garrison’s model. The purpose to develop a mathematical framework is to (1) show how such representation can be used and (2) layout a path for future work that requires a more flexible version of Garrison’s treatment than the graphical exposition. While the graphical model is limited to three dimensions, a mathematical version can include more variables of interest. First, we develop the mathematical framework of Garrison’s treatment. Then we apply it to the cases of increase in savings, secular growth, and the Austrian business cycle theory.
KEYWORDS: business cycle, Austrian School, Garrison
JEL CLASSIFICATION: B53, E32
- INTRODUCTIONThe contemporary literature on the Austrian business cycle theory (ABCT) is notably influenced by Garrison’s model (2001). This model offers clear guidelines to highlight the distinctive aspects embedded in the ABCT, specifically the effects of interest rate movements in the structure of production. The impact of Garrison’s model has been of such extent that, sometimes, it seems that Garrison’s model is being interpreted as being the ABCT instead of being one of the possible representations of the ABCT.While we are not arguing this is a “bad” thing, the model and Hayek’s triangle have also received some critical reviews (Barnett II & Block, 2006; Hülsmann, 2001). For an alternative framework to the ABCT in the field of finance, see Cachanosky & Lewin (2016) and Lewin & Cachanosky (2016).
In the theoretical literature, different extensions to the model have tried to account for open economies, growth, and risk (Cachanosky, 2014b; Fillieule, 2005; Ravier, 2011; Young, 2009, 2015). These papers extend Garrison’s models work by adding missing pieces that would allow for the model to offer a better explanation to business cycles such as the subprime crisis. In the empirical literature, the model has been used to illustrate how the predictions of the model can be seen with the available data. Typically, data at the industrial level are categorized as different stages of production and then the observed behavior is compared with the model’s predicted behavior (Lester and Wolff, 2013; Luther and Cohen, 2014; Mulligan, 2002, 2013; Powell, 2002; Young, 2005, 2012, 2015).Some authors offer an alternative approach; instead of categorizing industries as stages of production, the interest rate sensitivity of industries is compared. In the Garrison’s model framework, this means that each industry is argued to have a Hayekian triangle of a different size regardless of its position as a stage of production in the production structure (Cachanosky, 2014a, 2015b; Young, 2012). This approach does not deal with the problem of defining stages of production and still looks at industrial level data rather than aggregates. Both of these approaches present challenges. The literature shows that extensions to the model are not easy to display or interpret and that the empirical work requires putting forward assumptions too restrictive to either be realistic or offer valuable results.
Furthermore, according to Garrison (2001, p. xii), the graphical representation he offers should be interpreted to be more a pedagogical tool than a model to drive empirical reseach and develop theoretical nuances of the ABCT (italics original, bold added):
In the early 1970s I entered the graduate program at the University of Missouri, Kansas City, where I learned the intermediate and (at the time) advanced versions of Keynesianism. Having read and by then reread the General Theory, the ISLM framework struck me as a clever pedagogical tool but one that, like Samuelson’s gloss, left the heart and soul out of Keynes’s vision of the macroeconomy. It was at that time that I first conceived of an Austrian counterpart to ISLM – with a treatment of the fundamental issues of the economy’s self-regulating capabilities emerging from a comparison of the two contrasting graphical frameworks.For Garrison (2001, p. xiii) the model goes from being a pedagogical tool to be an instrument of persuasion (in the classroom): “But because the interlocking graphics impose a certain discipline on the theorizing, they help in demonstrating the coherence of the Austrian vision. For many students, then, the framework goes beyond exposition to persuasion.”
Garrison’s model value is also one of its main limitations. Like a demand and supply graph, Garrison’s model is able to say a great deal with just a few lines. But because Garrison’s model is a graphical one, it can only deal with at most three relationships (dimensions) at once. Besides the rapid increase in graphical complexity, the model is limited in the number of relationships it can handle at the same time. It is noteworthy that given the influence of Garrison’s model on contemporary ABCT literature, there is no mathematical framework of Garrison’s model that would allow for a more flexible model. If a graphical model exists, then a mathematical version is already implied in the model. This is the contribution of this paper. We introduce a mathematical, and arguably simple, model of Garrison’s graphical model. This simple model is not intended to be a definite version of Garrison’s model not to change what the model has to say, but a first step toward more complex and flexible versions as the contemporary applied ABCT literature seems to require.
The next section develops the mathematical model for Garrison’s model. Section 3 applies the model to two scenarios, increase in savings and secular growth. Section 4 applies the model to the ABCT case. Section 5 offers some suggestions of how this framework can be extended to offer different variations on a theme. Section 6 offers concluding remarks.
- A MATHEMATICAL MODEL FOR GARRISON’S MODELOur mathematical version of Garrison’s model requires making a few simplifications. The main difference between our version and Garrison’s model is that we use a linear production possibilities frontier (PPF). The reason for this is that a model with linear PPF facilitates algebraic calculations. As stated in the introduction, the purpose of this model is to offer some mathematical foundations to Garrison’s model, not a complex or a more realistic model. Figure 1 depicts the Garrison’s model we use in this paper.This would be figure 3.7 in Garrison (2001, p. 50).
Figure 1: Garrison’s Model with a Linear PPF
Before presenting the mathematical counterpart of this graph, a few clarifications are required. First, the interest rate defined in the market of loanable funds should be interpreted as a rate that represents the market yield (interest) curve. Investment decisions are valued with long-term interest rates, not with short-term interest rates (i.e. federal funds rate.) The ABCT argues that a credit expansion by the Federal Reserve puts into motion ABCT effects if the discount rate used by investors is affected as well. Put differently, this representation implicitly assumes parallel shifts of the yield curve, but no changes in the slope of the yield curve.Bernanke and Blinder (1992, 919) argue that the federal funds rate “is a good indicator of monetary policy,” and that the “Federal fund rate is particularly informative [of future movements in real macroeconomic variables].” Second, the PPF is not represented in terms of units of goods, like guns and butter, but in dollar amounts. This also means that one more dollar spent in consumption (investment) is one less dollar spent in investment (consumption) making a straight line PPF with slope negative one a plausible assumption. Total income (Y) is separated into consumption (C) and investments (I) (that in equilibrium is equal to savings [S]). This means that monetary illusion can confuse nominal increases of C and I with real increases (the exact location of the PPF is uncertain). Third, the base of the Hayekian triangle is intended to capture Böhm-Bawerk’s average period of production (APP). This means that the base of the triangle does not measure pure-time, but value-time. As Garrison (2001, p. 49) clarifies, “[t]wo dollars’ worth of resources tied up in the production process for three years amounts to six dollar-years (neglecting compounding) of production time.” Because the triangle assumes a constant flow of value-time, the APP is located in the middle of the base of the triangle. The length of the base (τ), then, measures the total period of production (TPP). The fact that the APP is one half of the TPP rests on a set of important assumptions. First, there is no compounding of returns. Second, there is a constant flow of value-in-time (this explains why the triangle hypotenuse is a straight line).For a more detailed discussion, see Cachanosky and Lewin (2014a), Cachanosky and Lewin (2014b) and Lewin and Cachanosky (2014). Finally, Austrians usually object to the interpretation that, in the ABCT, there is overinvestment when the theory argues for malinvestment. The model, however, is open to such confusion. The PPF is in aggregate terms and Garrison shows how the economy locates itself (temporarily) beyond its potential output where the level of investment is above its potential or when the unemployment is below its natural rate. τ increases as well. This suggests overinvestment. More roundabout methods of production can also be interpreted as overinvestment rather than malinvestment because this concept is associated with capital intensity. We do not claim that the ABCT argues for malinvestment while Garrison’s model argues that the main problem is overinvestment, but it should be pointed out that the model itself is open to the latter interpretation.
The model has four equations, (1) supply and (2) demand for loanable funds, (3) the PPF, and (4) Hayek’s triangle hypotenuse. The unknowns in the model are I,r,C,and τ.
(1)
(2)
(3)
(4)
Where ID and IS are the demand (investment) and supply (savings) for loanable funds respectively. Ȳ is a given value of total output that is divided between consumption (C) and investment (I); this is the PPF. We should note that we assume this is a closed economy with no government.For a treatment of Garrison’s model with government, see Ravier and Cachanosky (2015). The Hayekian triangle’s hypotenuse is represented by the fourth equation, which has a zero intercept and slope i. Also A,B>0,A>B, and α,β>0.
The model can easily be solved. First, from the market of loanable funds we can obtain the interest rate and investment values of equilibrium. Second, the equilibrium level of investment can be used to obtain the equilibrium level of consumption. Third, with the level of consumption and of the interest rate the total and average period of production in equilibrium can be calculated.
(5)
(6)
(7)
(8)
(9)
An increase in the demand for loanable funds (ΔA>0) or a reduction in the slope of the demand (Δα<0) implies an increase in iand I. Similar effects can be tracked for changes in the supply of savings in the market for loanable funds through a comparative static analysis of each parameter for i or I.
We should note that the consumption function is a linear function with an intercept Ȳ and a slope equal to negative one with respect to I. This also means that, in our model, all else equal, an increase in Ȳ results in an increase in consumption but not in investment. This is because the PPF is assumed to be linear where each dollar that is not spent in C is spent in I. An increase in demand (ΔA>0) or supply (ΔB>0) for loanable funds reduces the level of consumption as more resources are devoted to investment given a level of output. Finally, we can obtain τ (TPP) and the APP from the Hayekian triangle. The total and average periods of production are directly related to the size of the economy (Ȳ). Since τ has to be positive, it follows from equations (7) and (9) that investment cannot be larger than the output: .
We can calculate the area of the Hayekian triangle (H) which is the sum of all stages of production. This would be analogous to the gross domestic expenditures (GDE).The Gross Domestic Product (GDP) equals Gross Output (GO) plus Intermediate Expenditures (IE), and GO equals GDP plus Intermediate Investment (II). Then, GO = GDP + II and GDE = GO + IE. This area amounts to the total time-value investment of the structure of production and can be obtained by multiplying t with C and dividing by two:
(10)
- APPLICATIONS3.1 Increase in Savings
A change in time preference towards an increase in savings can be captured by a positive change in B (ΔB>0). This means that, at the same interest rate in the market, economic agents are willing to supply more loanable funds. The comparative statics are straightforward.
(11)
(12)
(13)
(14)
As expected, the increase in savings reduces the interest rates. It results also in an increase in investment equal to the reduction in consumption . But the effect on τ (and, therefore, on the APP) depends on the sign of (Ȳ-A). Intuitively, this captures the opposite effects on APP of (1) a fall in interest rates and (2) a fall in consumption. Finally, we should add that, because, , if , then (the area of the Hayekian triangle decreases as well because both, height (C) and width (τ) are falling). Figure 2 shows the results (with an increase in τ).This would be Figure 4.2 in Garrison (2001, p. 62).
Figure 2: An Increase in Savings in Garrison’s Model
3.2 Secular Growth
Garrison (2001, Chapter 4) presents the case of secular (technology-induced) growth. Garrison assumes that the technology growth has no effect on the level of interest rates. This case can be divided in two steps. First, the new technology increases the demand for savings by the firms. Second, there is an increase in the supply of savings after income increases. Therefore, the interest rate rises first and then it returns to its original level. Figure 3 reproduces Garrison’s (2001, p. 59) Figure 4.1.
Figure 3: Garrison’s Secular (Technology-Induced) Growth
To follow Garrison’s exposition as closely as possible, we need to make three modifications to our model. First, we modify the market for loanable funds to make demand and supply of savings depends on technology and income respectively; this allows following Garrison’s two steps. Second, we need to add time (t). Third, we need to add a production function to capture growth. The model now becomes the following:
(15)
(16)
(17)
(18)
(19)
(20)
Subscript t denotes time, Y is not a given value anymore and follows a Cobb-Douglas production function where Z is technology, K as capital, as a given amount of labor, and γ (0,1). Finally, δ (0,1) is the depreciation rate. For a steady state where K(t+1)=Kt, we need It*=δKt. This means that the equilibrium interest rate in the loanable funds market yields an investment value of δKt. The equilibrium conditions now become the following:
(21)
(22)
(23)
(24)
(25)
(26)
(27)
3.2.1 Short-run effect
Taking this steady state as our initial position, assume now a positive shock to technology in period t.
(28)
(29)
(30)
(31)
(32)
(33)
In the short run, the effect on τ depends on whether the increase in C (height of the triangle) more than compensates the increase in i (slope of the triangle); recall that . Note that output (equation 33) increases because there is better technology and because there is an increase in capital (equation 32). The excess of investment over capital depreciation increase income in future periods and, with this effect, there is an increase in the supply of savings.
3.2.2 Long-run effect
In period t+1 the investment and the stock of capital continue to increase. The increase in K continues until period T≥t+1 where, again, IT*=δKT.
(34)
(35)
(36)
(37)
If the increase in ITS is such that it=iT then we obtain Garrison’s secular growth graphical representation shown in Figure 3. The effects of our model are captured in Figure 4.
Figure 4: Garrison’s Model with Secular Growth
- GARRISON’S VERSION OF THE AUSTRIAN BUSINESS CYCLE THEORYGarrison’s representation of the ABCT overlaps Figure 1 with the effects of an expansion of credit by the monetary authorities. The monetary authorities’ action results in a secondary supply of loanable funds that reduces i and produces an unstable situation where I and C try to increase at the same time beyond the limits of the PPF. The detachment of i from economic agents’ time preference results in saving and investment not being equal anymore. The reduction in i increases τ, but the increase in consumption increases the height of the triangle. The inconsistency of trying to increase I and C (the boom) for a given Ȳ pulls the triangle on both sides, “breaking” the hypotenuse of the Hayekian triangle. The exact location where the hypotenuse breaks depends on the slope and relative effects on C and τ. The longer this tension is in place and the farther away i is from the equilibrium level, the more malinvestment is accumulated and the costlier the correction (the bust) will be. To capture Garrison’s version of the ABCT we need to add a function that represents the supply of loanable funds with the monetary authority intervention (G).
(38)
(39)
(40)
(41)
(42)
Where G represents the credit expansion by the monetary authorities. Garrison’s model applied to the ABCT requires us to pay attention to three sets of points. First, the equilibrium values absent the central bank intervention, denoted with superscript * (already solved above). Second, the values that originate from the supply of credit with the monetary expansion of the central bank. These are denoted with a subscript g. Third, the values that originate from the supply of loanable funds without the government. These private market values are denoted with the subscript p. Following the same steps than above, we can solve the model for the case of credit expansion
(43)
(44)
(45)
(46)
(47)
From equation 46 we can calculate the change in τ when there is an increase in credit (ΔG>0) and the elasticity of τ with respect to G . These two measures give us a proxy of the degree of roundaboutness sensitivity to the central bank intervention in the market for loanable funds.For the elasticity to be positive, the following two restrictions are required:(1)((α+β) Ȳ-(βA+αB)-αG) · (A-B-G)>0,(2)(Ȳ-A)>0.
(48)
(49)
We can also measure the deviations between the market position with the central bank intervening and the market position in the base case without the central bank intervening.
(50)
(51)
(52)
(53)
We can now calculate the values for the market without the central bank intervening. In this case, the market reacts to ig but yields an implicit ip that represents the slope for late stages of production. This implicit rate is the one that prevails at the demand for loanable funds given the private supply of funds at ig*.
(54)
(55)
(56)
(57)
(58)
Similarly, we can measure the deviations of the market from the base scenario when the central bank intervenes in the market for loanable funds.
(59)
(60)
(61)
(62)
The credit expansion by the central bank pushes the economy beyond the PPF by the amount G, which is distributed between the deviation in investment and consumption.
(63)
(64)
The next step is to calculate the difference between the economic variables affected by G and the market reaction to the central bank’s monetary policy.
(65)
(66)
(67)
(68)
With these results we can also calculate the value of τ where the Hayekian triangle “breaks.” Because we have two interest rates (ig and ip) we have two Hayekian triangles. The rate ig defines the slope of the hypotenuse for early stages of production. The rate ip defines the slope for late stages of production. We call the value of τ where both hypotenuses meet τB. We can estimate this value from the fact that both levels of consumption are the same (CB) where the two hypotenuses intersect.
(69)
(70)
(71)
(72)
4.1 A Numerical Example
As a final application, we offer a numerical example. For brevity, we show only a case for equilibrium and the ABCT case.
Let us calculate first the equilibrium in Garrison’s model. Assume that A=10,B=0,α=0.5, β=0.5, Ȳ=100. Then, using equations 2 to 6, the equilibrium values are i=10,I=5,C=95,τ=9.5,APP*=4.75,H=451.25.
Assuming now that government increases credit supply by amount G=2, using the model in section 4 we can calculate the government and private equilibria and the deviation from Garrison’s base scenario equilibrium.
With these values we can calculate the change of τ with respect to the increase in credit supply (G): . Finally, we can also estimate the point where the Hayekian triangle breaks and the area below the broken triangle:
.
Figure 5: Area of the Hayekian Triangle in the ABCT Case
Not surprisingly, this calculation yields a higher value for the area below the hypotenuse than the base case in Garrison’s model because private consumption plus investment is outside the PPF by 2, the assumed value of credit expansion; HABCT=552.75.Because the slopes for demand and supply of loanable funds are the same (in absolute values), consumption and investment both increase each by 1. This is another result that invites to the overinvestment interpretation of the ABCT.
- CONCLUDING REMARKSConcurring with Garrison (2001, p. xii), this paper argues that ABCT’s graphical model is limited in its ability to develop theoretical extensions to the ABCT and to be subject to empirical falsification. This paper develops a basic mathematical model of the ABCT as an alternative to Garrison’s graphical model to avoid some its limitations. In this paper, we also attempt to show how this basic mathematical model is applied and vary when we consider the various applications and extensions that Garrison’s (2001) graphical representations cover.
As Garrison’s model, the simplicity of our mathematical representation of the ABCT is limited itself in its ability to be empirically tested. There are several possible extensions to the model that can be done to make it more applicable to explain economic crises.
First, two extensions come from applications of the ABCT to the subprime crisis. Cachanosky (2014c) and Young (2012a) apply the ABCT to open economies and add a risk variable. The former does not use Garrison’s model, and the latter acknowledges the difficulties of adding financial risk to the graphical version of Garrison’s model. A mathematical model would allow adding more variables to the model in order to extend its applicability and help avoid graphical ambiguities. Foreign exchange rates (nominal and real), imports, exports, and risk variables are just a few variables that the ABCT needs to add to be able to fit contemporary business cycles.
Second, there are other possible extensions to the model that could be made to help the model better measure some specific aspects of the ABCT. For example, the model could add a Phillips curve to the model to capture the effects on unemployment during a boom-bust cycle and offer a direct comparison with alternative theories like the Keynesian framework similar to Ravier (2013). The model can measure labor movement across industries by adding a labor market to different stages of production (Garrison, 2001, Chapter 10; Young, 2005). Adding the government sector would allow to analyze the different effects that different ways of financing government spending would have (Ravier and Cachanosky, 2015). Does the government finance the deficit with credit expansion, increase in taxes, domestic debt, or foreign debt?
Instead of looking at the ABCT from a stage-of-production viewpoint, the model could instead incorporate different industries. In Garrison’s model, the stages of production are assumed to be well defined and ordered. This assumption fulfills the role of capturing the fact that production takes time and that there is a structure of production that is efficient and avoids shortages or surpluses. But the real world is not divided in similar fashion. Each industry can be thought of as its own triangle and all of them are interconnected providing goods and services to each other (looping). A mathematical version of Garrison’s model can add n industries with different APP and capture the relative effect on each one of them.
Finally, the model could also incorporate entrepreneurship into its analysis. For example, it could add two entrepreneurs, a savvy and a naïve one, to show that the ABCT is not built upon representative agents but that relies on heterogeneous entrepreneurs (Cachanosky, 2015a; Callahan and Horwitz, 2010; Evans and Baxendale, 2008). A mathematical framework like the one we present in this paper opens the opportunity to explore more complex versions of Garrison’s model.
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The Quarterly Journal of Austrian Economics
Vol. 19 | No. 2 | 149–168Summer 2016
Is There Such a Thing As a Skyscraper Curse?
Elizabeth Boyle, Lucas Engelhardt, and Mark ThorntonElizabeth Boyle is a former intern with the Mises Institute. Lucas Engelhardt (lengelha@kent.edu) is Associate Professor of Economics at Kent State University, Stark Campus. Mark Thornton (mthornton@mises.org) is Senior Fellow at the Ludwig von Mises Institute and teaches at Auburn University.
ABSTRACT: There is an emerging literature on the subject of skyscrapers and business cycles. Lawrence (1999) first noticed the correlation between important changes in the economy and the building of record-breaking skyscrapers. Thornton (2005) established a theoretical link between the two phenomena. Several papers have subsequently examined the impact of skyscraper building on the economy and in particular on the role of psychological factors on the building of record-breaking skyscrapers. Not surprisingly, most people scoff at this notion, and Barr et al. (2015) present extensive empirical evidence that skyscrapers do not cause changes in GDP, but precisely the opposite. Here we show what the skyscraper curse actually is, and show that the entire empirical literature on this subject supports the existence of a skyscraper curse, including most of Barr et al. (2015). In addition, we present new empirical evidence supporting the skyscraper curse.
KEYWORDS: Skyscraper Curse, business cycle, Austrian SchoolJEL CLASSIFICATION: B53, E32, E37, R11INTRODUCTIONOn March 28, 2015, the Economist magazine published an article that is the title of this paper. They came to the conclusion that there should be great doubt about the existence of the skyscraper curse. “In other words, you cannot accurately forecast a recession or financial panic by looking at either the announcement or the completion dates of the world’s tallest building.” The Economist article is just the latest installment of the increasing fascination of the financial and news media with the skyscraper curse.
There has also been an increasing attraction of economists to the relationship between skyscraper building and economic crises. Several economists have examined the data and tried to make sense of the suggested correlation to determine the underlying causes and relationships. This all began with Andrew Lawrence (1999), the founder of the skyscraper index who coined the phrase “skyscraper curse.” He believed building booms were the result of easy credit conditions and expansionary monetary policy. Lawrence focuses on “over investment, monetary expansion and speculation” as the basis of building record-breaking skyscrapers and that when this pattern cannot be sustained the economy falls into economic crisis. Thornton (2005) provides both a theoretical model for the skyscraper curse and additional evidence in support of the curse.
In contrast, another thread in this literature is based on the idea that skyscraper building is rational and that skyscraper construction does not cause economic crises. In particular, Barr et al. (2015) present extensive empirical evidence that skyscraper construction is rational and that skyscraper construction does not cause changes in GDP. The argument presented here is that all the empirical evidence in this literature actually confirms the same thing: the existence of the skyscraper curse. This in turn provides for a more complete understanding of just what the skyscraper curse means, as well as its cause.
HISTORY AND DEBATELawrence (1999) bases his correlation on an examination of the record-breaking skyscrapers that occurred over the previous 100 years. He begins with the Singer Building and the Metropolitan Life Building, which were completed in 1908 and 1909 respectively. These new records occurred concurrently with the Panic of 1907. He notes that there is a remarkably accurate relation between the two variables over the next century, with the exception of the Woolworth Building which was completed in 1913.
Lawrence’s article and research was the jumping off point for many economists to follow. Thornton (2005) shows how artificial interest ratesArtificially low interest rates occur when actual rates are below levels that would have existed if they were solely determined by market forces. As such, pure market rates are not observable and are difficult to estimate although you can get some sense of their effect by examining data on total lending in the economy. link skyscraper height and economic crises. Artificially low interest rates and sustained easy credit conditions allow for both a booming economy and record-breaking skyscrapers. The causal link is based on three different Cantillon effects involving artificially induced structural changes that occur throughout the economy. The three effects work together to both cause an abnormally large expansion in the economy and the building of record-breaking skyscrapers.
The first Cantillon effect is the impact of the rate of interest on the value of land and the cost of capital. A lower interest rate causes land values to increase, especially in high-value areas such as metropolitan cities. Lower rates increase land prices due to, among other things, the decreased opportunity cost of owning land. Higher land prices lead builders to build taller, more capital intensive structures in order to better maximize profits. This is well-known through theory and experience (Capozza and Li, 1994) and this effect is also confirmed empirically in some of the papers reviewed below.
The second Cantillon effect from artificially low interest rates is an increase in the size and scope of firms. A lower cost of capital encourages firms to grow in size and to become more capital intensive and to take advantage of new technologies and economies of scale. In particular, it encourages firms to engage in more roundabout production processes. An example of adopting a more roundabout production process would be when local dairy firms are replaced by regional dairy firms. As local firms are replaced by regional firms and regional firms are replaced by national and international firms, there will be an increased demand for office space for corporate headquarters, especially in central business districts of major metropolitan cities. Empirical support for this effect can be seen in Harford (2005) who shows that merger waves are dependent on “sufficient overall capital liquidity” and that such waves do not occur in the absence of this liquidity.
The third Cantillon effect from artificially low interest rates is the development of new technologies and production processes needed to produce record-breaking skyscrapers. Record breakers typically require new innovations and efficiencies in order to effectively reach record heights. In terms of construction, building higher structures often requires new types of cranes, cement pumping systems, etc. In terms of the actual structure, building higher often requires newer and faster elevators, lighter cables, new efficiencies in moving water and sewage, space saving temperature control systems, etc. Ali and Moon (2007) show that designers and engineers have a tremendous desire to innovate with technology in order to conserve on the size of building systems or to increase the capacity of those systems. For example, just one standard elevator shaft of 2x2 meters would take up the space of 10 efficiency apartments in a 100 story building. At standard speeds, it would take about 10 minutes to get from the ground floor to the top floor of the Burj Khalifa Tower, plus the time it took for the elevator to arrive at the ground floor. Therefore as building height rises, technology must also advance to conserve on the building systems footprint. Ames (2015) reports, for example, that KONE engineers have created a new elevator cable that weighs less than 7 percent of the weight of traditional steel cables, which weigh over 20 tons for a 400 meter building.
Cantillon effects explain why buildings are built taller, firms become larger, and technologies are developed that would otherwise be uneconomical all during periods of artificially low interest rates. There are two things to take note of here. First, these effects are not limited to the record-breaking buildings, but are present throughout the economy. Second, it might at first seem that some of these effects, such as technological change, are beneficial, but they are all inconsistent with the most efficient use of resources. All three effects are typically revealed when interest rates adjust to market-determined levels as a cluster of entrepreneurial errors consisting of unrealized profits, foreclosures, bankruptcies, unemployment, and often bailouts.In the event that interest rates are not allowed to return to higher market-determined levels, keeping interest rates from rising requires a commitment to expanding the money supply at an increasing rate—which runs the risk of hyperinflation.
In addition to describing the Cantillon effects that give rise to the Skyscraper Curse, Thornton (2005) shows that the Woolworth Building—which Lawrence saw as an exception to the curse—was not really an exception because World War I intervened lifting the US economy out of a steep slide into recession. Thornton also extends Lawrence’s data to include the late 19th century—showing that record height buildings in that period also followed the Skyscraper Curse.
Kaza (2010) supports Thornton’s arguments concerning the role of Cantillon effects, and entrepreneurs are not immune to the errors that are eventually revealed as an economic contraction. He also supports Thornton’s position that the Woolworth Building was not an exception to the Skyscraper Curse. He points out that the Woolworth Building and other less severe cycles match up well, but not consistently with cycle data provided by the National Bureau of Economic Research. Kaza also shows that there is some evidence of the skyscraper curse at the state level as exemplified by the history of tall buildings in Arkansas and Michigan and that the tallest building in 40 of the 50 US states were completed during economic contractions, as defined by the National Bureau of Economic Research
Loeffler (2011) also examined record-breaking skyscrapers to determine whether they can be used to forecast US stock returns. He finds that during the five years after construction of a record-breaking skyscraper, the stock market returns are substantially lower than they were in the years prior. Loeffler shows this result is due to “over optimism” in the economy which gives rise to skyscraper building, but also leads to an overvalued stock market. Using data from the US from 1871–2009, Loeffler’s statistical analysis shows a relationship between the building of skyscrapers and in changes in the stock market. Loeffler finds that stock returns are associated with the information regarding the start of a record-breaking skyscraper and then the two years following. Loeffler uses these findings to test the determinants of skyscraper building, and notes that they are able to capture market conditions such as risk and confidence. His prior analysis shows weak evidence of overvaluation, but through these tests he is able to conclude that there is a stable and significant relationship over time. He finds that the “predictive content of tower building is at least partly related to overvaluation” (Loeffler, 2011, p. 2).
Jason Barr has examined different determinants of skyscraper height in several papers. Barr (2010) began by examining Manhattan, once the skyscraper capital of the world. Here he looked at skyscraper height in Manhattan from 1895–2004 as both a function of economic variables and “builder competition.” Here a skyscraper is defined as a building over 100m in height. He identified skyscraper building cycles that appear to last about twenty five years, giving rise to the thought that “their construction is determined by major economic, demographic, and political forces” (Barr, 2010, p. 568). In areas such as Manhattan, height is the easiest way to make the most of the relatively scarce land, in turn maximizing profit. However, Barr also expresses the notion that building height is also affected by “builder competition”—the builder’s desire to “obtain a degree of societal status” (Barr, 2010, p. 569).
Barr shows that there is a high degree of correlation between the number of completions and the height of each completed building. This demonstrates that fertile economic conditions encourage taller buildings to be built. He also shows that the level of building activity is dependent on employment in the finance, insurance and real estate industries as well as the stock market and other economic factors such as building material prices and interest rates.
He then expands his model to include ego variables to look for a trend between completions and heights. Barr finds that since the beginning of the 20th century, height trends have been determined by economic factors that affect building costs. He considers that if ego was playing a significant role in the height of skyscrapers, there would have a trend between height and completion of buildings in the surrounding area. However, Barr did not find such evidence, so that his time series tests provide “support for the profit maximization hypothesis, rather than the ego hypothesis” (Barr, 2010, p. 570). However, Barr still believes that “record breaking height appears to be due to the right combination of ego and economics” (Barr, 2010, p. 592) because ego competition can only take place once the economy is in a solid position to build.
Barr (2012) next examines skyscraper height as a function of cost, benefits of construction and “height competition.” He finds that skyscrapers “not only provide profits but also social status” for both the city and for the architect because a new skyscraper announces to the world that a city has arrived as an economic power. To a builder, a record-breaking skyscraper is also strategic. By standing out in the city skyline and the record books, the architecture and construction companies “build” status in society and their business communities. Social status can be viewed as ego in the height competition between builders or between cities.Helsley and Strange (2008) had previously presented a game-theoretic model for skyscraper height, which suggests the hypothesis that Barr (2010b) is testing. He employs a variety of models to test responsiveness to nearby buildings and he determines “that builders positively respond to the height decisions of nearby buildings.” To start, Barr creates a model of the height of skyscrapers in New York from 1895–2004. Through various economic variables Barr is able to measure construction costs and profits. He is able to determine which of the skyscrapers were economically too tall at the time they were built and which buildings responded to the building of nearby skyscrapers. His results show support for the “height competition” hypothesis, i.e., ego matters, and that height competition is at its peak during times of economic expansion, when the “opportunity cost of seeking social status is lower.” Barr also finds evidence that economic factors such as a fall in interest rate and building costs or an increase in population and job growth all increase height.
To look further into the strategic interaction underlying the competition hypothesis, Barr (2013) looked for evidence of building competition between New York and Chicago to determine if there is a “height race” and “strategic interaction” between the two cities (Barr, 2013, p. 369). In order to test to see if there is competition Barr creates an annual time series of the number of skyscraper completions in each city. For each city Barr uses a different cut off in defining what buildings qualify as a skyscraper. In Chicago he uses 80 meters, and in New York he uses 90 meters. From the data of the qualifying buildings, Barr creates a time series of the number of skyscrapers in each city to determine if building in one city had an impact on the other. Based on the assumption that such competition would take place at the highest level of buildings, he looks at the tallest building completed in each city during each year since 1885.
Barr does indeed “find evidence for skyscraper interaction across cities. That is, New York skyscraper decisions have impacted Chicago decisions and vice versa.” (Barr, 2013, p. 370). Barr also examines zoning regulation changes over this time period and is able to see that as zoning regulation intensifies in one city, building in the other city increases. This suggests that the cities not only act as complements to one another, but also as substitutes. That is, when building is increasing in one city, it will also be increasing in the complement city. However, when zoning restrictions are intensifying in one city, building will increase in the other city. Although Barr does find evidence of height competition, he suggests that this height competition is only evident when the opportunity cost of competition is low.
In the most recent article by Barr, with coauthors Bruce Mizrach and Kusam Mundra (2015), the existence of the Skyscraper Curse is brought into question. In order to test for the Skyscraper Curse, Barr et al. (2015) examine record-breaking skyscraper building patterns and compares that with announcement dates and opening dates to determine if there is a correlation with GDP growth. They determined that there was “no relationship between record-breakers and recessions” (p. 149). Additionally, they used vector auto regression analysis for the annual time series of the tallest buildings completed in US, Canada, China and Hong Kong and their respective real GDP per capita. From these regressions they performed Granger causality and cointegration tests to determine the relationship between real GDP per capita and the time series data of tallest buildings completed in each country. They concluded that real per capita GDP and height are cointegrated, meaning that height and GDP per capita share a common pattern. Additionally, they find that “there is unidirectional causality from GDP to height.” They therefore conclude that “height is not a useful predictor of the business cycle, and that while height may temporarily deviate from output, over the long run height and output move together.” They believe these “temporary deviations” are the result of builder competition that results in taller buildings that are economically too tall, and that during a correction period construction height falls back towards a level consistent with GDP. Their evidence appears to create a strong dispute of the existence of the Skyscraper Curse.
The most current academic paper on this topic is Engelhardt (2015). He uses a Bid Rent function in residential cities to show what a buyer would be willing to pay for a given piece of land at a given time. Bid Rents decrease as one moves further from the city center due to the increase in transportation costs, leaving less money to spend on rent. Using this model he found that, “land prices will vary in proportion with rents, and will vary in inverse proportion with interest rates” (Engelhardt, 2015, p. 4). Therefore one can arrive at the conclusion that “land prices in the city center are typically higher than in the periphery” (Engelhardt, 2015, p. 4). He finds that height will increase if building up, or adding height, is less expensive than building out, or a more spread out building. “Land prices increasing will occur if land rents increase, or if interest rates decrease” (Engelhardt, 2015, p. 5). He also asserts that interest rates have an impact on wage rates. “A decrease in the interest rate leads to greater demand for labor… and therefore higher wages” (Engelhardt, 2015, p. 6).
Engelhardt uses these findings to demonstrate that higher wages from lower interest rates, increases the cost of transportation from the opportunity cost of not working. This shows that the increased incomes will change the demand and budgeting for rent, raising the bid rent function. This function is additionally steepened by the higher cost to transportation from the higher opportunity cost of a commute. This demonstrates that the boom increases demand for living in the city center. These effects will give rise to an increase in land prices in the city, due to the new higher income and due to the decrease in interest rates. These new higher land prices make it more cost efficient for buildings to build up rather than out, thus economizing their land usage.Chau, Wong, Yau, and Cheung (2006) find similar results—that optimal building heights rise when land is scarce.
In looking at the various papers and research, there appears to be considerable uncertainty and doubt regarding the Skyscraper Curse. Some papers seem to conclude that record-setting skyscrapers are indeed a curse. Several papers offer evidence of a variety of causes of the curse including monetary policy, various supply and demand factors, as well as psychological factors such as overvaluation, builder competition and ego. There is also a suggestion that the Skyscraper Curse, like other stock market indicators, is a figment of our imagination and the result of happenstance. In the next section we show there is much less disagreement than it appears.
THEORY AND HARMONYWhen considered together, current research seems to conform to the theoretical description provided by Thornton (2005). Clearly there is a coincidence of economic expansion, higher stock prices, psychological changes and skyscraper construction prior to an economic crisis. If all of these phenomena share a common cause, then it should be no surprise to find that they are empirically connected. As Thornton (2005) establishes, lower interest rates serve as that common cause. So, while there is a Skyscraper Curse—in that skyscrapers are an omen of sorts—the skyscrapers do not cause the financial collapse that often follows. They are simply a very visible manifestation of the business cycle phenomenon brought about by artificially low interest rates.
Despite the general agreement regarding some of the key elements of the Skyscraper Curse story, there are certain deviations among the empirical papers. Thornton (2005) describes the Skyscraper Curse in terms of a rate of interest in the market that deviates from the pure market-determined rate of interest—a deviation that is unsustainable. Loeffler (2011) believes that unjustified economic optimism leads to both skyscraper building and stock market overvaluation. The two agree, then, that the Skyscraper Curse is brought on by a temporary, passing phenomenon that must be followed by some correction, while they disagree about the precise cause. Thornton supports the case for an economic cause in the form of a distortion in interest rates while Loeffler and others support the case for a psychological cause in the form of undue optimism.
So there are really two threads in the literature regarding the skyscraper curse. Lawrence (1999), Thornton (2005), Kaza (2010) Thornton (2014), Engelhardt (2015) and Engelhardt and Thornton (2015) all rely on the notion of a distortion of interest rates and the resulting monetary and credit expansion to explain the connection between record-breaking skyscrapers and economic crises. The other thread involves various psychological explanations, including Barr (2010) “builder competition” which involves ego and social status, Loeffler (2011) “over optimism,” Barr (2012) “height competition,” Barr (2013) “height race and strategic interaction.” Lawrence, Thornton, Kaza, and Engelhardt provide no hard evidence, only connections to the obviously low rates of interest and credit expansion. In contrast, Barr and Loeffler do provide hard evidence to back their stories of pop psychology. No matter who is right, the primary point is that both sides basically agree that there is some kind of distortion that helps correlate skyscraper construction with significant economic turns of the business cycle.
The one paper that does appear to openly quarrel with the existence of the Skyscraper Curse is Barr et al. (2015), which concludes that there is no curse. There are two primary points that would suggest their opposition to the curse. First, they show that the date of announcements and openings for record-setting skyscrapers do not empirically fit the pattern of changes in GDP growth. Second, they show that skyscrapers do not (Granger) cause economic crises and that both are part of a common trend i.e. cointegrated. However, a reinterpretation of Barr’s work can allow it to support the existence of the Skyscraper Curse.
First, Barr (2013) suggests that skyscraper building is a combination of ego and economics—but that ego appears to only be unleashed when economic conditions are right. This lines up well with Thornton (2005)’s pro-Skyscraper Curse argument. When interest rates are artificially lowered because of credit expansion, skyscraper building is unleashed. In the end, skyscraper builders overestimate the value of height, an idea supported by Engelhardt (2015). Low interest rates also decrease the cost of pursuing social status. So, Barr’s observations in this regard are supportive of the Skyscraper Curse.
Second, there is no particular reason that announcement, record setting, or opening dates should have a specific, precise relationship with business cycle peaks. There is no theoretical reason offered by Lawrence (1999) or Thornton (2005) that any of these dates can serve as a variable in a regression, for example. Skyscraper building is, at best, imprecise in its timing. All major construction projects are subject to idiosyncratic variations arising from work stoppages, regulatory delays, accidents, fires, and so on. The Skyscraper Curse is imprecise by nature. While this imprecision may invalidate (or at least complicate) statistical testing of the Curse, it does not invalidate the underlying logic of the Curse. So, Barr’s observation that there is no strict correlation between these dates and business cycle peaks does not invalidate the existence of the Skyscraper Curse. The problem of using announcement and opening dates in this type of analysis is discussed more fully in Engelhardt and Thornton (2015). Thornton (2014) shows that groundbreaking and topping off dates are more relevant dates than announcement and opening dates.Thornton (2014) claims that ground breaking dates should be used as for a “skyscraper alert” for future economic trouble and that record-breaking dates should be used for “skyscraper signals” that suggest economic danger is imminent. The reader can compare the relationship between announcement, record breaking, and opening dates of record skyscrapers with historic economic crises in Table 1 below.
Table 1
Third, Barr et al.’s (2015) work suggests that in terms of Granger causality (which is designed to establish timing rather than true causality in a scientific sense), increases in GDP Granger-cause building height. That is: economic booms begin before buildings begin increasing to record heights. Because of this, it is unreasonable, according to them, to suggest that the building of record-setting skyscrapers causes economic crises. However, this observation is perfectly consistent with the Skyscraper Curse. The Curse suggests that both skyscraper building and unsustainable economic booms are caused by the same underlying phenomenon: artificially low interest rates that fuel unsustainably easy credit conditions. It is, in fact, no surprise that, on average, economic booms precede increased building height in time. Buildings—skyscrapers especially—take a great deal of planning before they can be undertaken. This planning creates a lag between the initial cause (the low interest rates) and the effect (record-breaking skyscrapers). This lag may certainly be longer than the average lag for many or most interest-rate sensitive businesses. Those industries that can respond to interest rates more quickly do so—leading to the beginning of the boom. Those that can only respond more slowly—like skyscraper construction—only respond with a substantial lag.
How then can we explain the apparent disagreement? One possibility is that the seeming disagreement comes from an underlying methodological difference between the proponents of the Skyscraper Curse and those who deny it. The proponents—Lawrence (1999) and Thornton (2005) especially—rely on an underlying explanatory logic, and accept that any attempt to use data to make precise predictions about the onset of a crisis are likely doomed to failure. The connection in the timing is, by nature, imprecise. Record-breaking skyscrapers are unique events, and the timing of any particular date (announcement, record-setting, or opening) in relation to the larger business cycle is going to be imprecise, especially as the building of the skyscraper has no direct causal connection with the crisis. Much like the canary in the coal mine serving as indicator of toxic air conditions in a mine, skyscrapers can indicate that the economy has experienced an unsustainable credit expansion that must reverse itself in an economic downturn. Unlike the canary, skyscraper construction takes a long time to respond to economic conditions, and takes a long time to complete—and both of these lags allow for idiosyncratic variations. These variations, however, do not invalidate the underlying logic.
Those who deny the existence of the Skyscraper Curse tend to rely heavily on the necessity of data to show its existence. This method faces serious challenges for some reasons already described. First, the timing of skyscraper construction is influenced by many factors other than the phase of the business cycle. Second, record-breaking skyscrapers in particular provide only a very small sample size. Thus, we see that Barr, et al. (2015) only has 14 examples of record-breaking skyscrapers with which to test the prediction hypothesis—as a result, any statistical test is likely to be underpowered, and they simply note that there is a wide range of lags between skyscraper announcement and opening dates and business cycle peaks and troughs. But, simply looking at the range of a data set only tells us that the relationship is affected by factors outside those being considered or that the quantitative relationship is not perfectly constant. But, proponents of the Skyscraper Curse do not claim that skyscraper records are the cause of the business cycle, nor do they claim that the relationship is going to be quantitatively constant.
That said, to provide some kind of statistical evidence to call into question the work of Barr et al. (2015), we provide some very simple statistical evidence on the odds of being in a NBER-declared recession 12 months after a record breaking skyscraper on Table 1 was completed. The concerns that this evidence hopes to answer are threefold: (1) By considering months rather than skyscrapers, the sample size increases substantially—from 16 skyscrapers to 1510 months, allowing statistical approaches that Barr et al. (2015) could not use. (2) By considering only record breaking skyscrapers, this work is more true to the Skyscraper Curse’s claims than Barr et al.’s (2015) Granger-causality tests using average construction height. (3) By allowing a reasonably long window of 12 months, the test does not assume a specific number of months passing between skyscraper completion and recession. (So, we are testing the idea that, after skyscraper completion, the economy will be in a recession some time during the next year—not that the recession will start exactly 12 months after the skyscraper is completed.)
For our data, we constructed two dummy variables. The first took the value of one if the NBER considered that month to be part of a recession, and zero otherwise. The second took the value of one if there was a record-breaking skyscraper completed in that calendar year, and zero otherwise. In performing the analysis, each month’s values were based on the current recession dummy and the skyscraper dummy from 12 months prior. (So, a value of one in March 2008 indicates that a record-breaking skyscraper was completed at some point in 2007.) These dummy variables were used to divide every month from January 1890 through October 2015 into one of 4 categories: (1) No skyscraper, no recession, (2) No skyscraper, recession, (3) Skyscraper, no recession, (4) Skyscraper, recession. If the Skyscraper Curse were strictly true, then sets 2 and 3 would be entirely empty. However, recall that the Skyscraper Curse claims to predict major financial crises—not necessarily every recession. Rather than attempt to define what constitutes a “major financial crisis,” we simply point out that the Skyscraper Curse would just predict that recessions are more likely following skyscraper construction than not following skyscraper construction.
Table 2
Table 2 summarizes the results. To check for a significant difference in the odds of a recession following skyscraper construction, we can do a simple comparison of the proportions involved. In months shortly after a record breaking skyscraper was constructed, there is a 56.25 percent chance of being in a recession. In months that are not shortly after a record breaking skyscraper was constructed, there is a 23.07 percent chance of being in a recession. This difference of 33.18 percentage points has a z-value of 8.82 in the comparison of these proportions—so this difference is statistically significant. Subjectively, though, this difference seems to be not just statistically significant, but economically so. After all, the months following skyscraper construction have a more than 50 percent chance of being in a recession. Those not following skyscraper construction have a less than 25 percent chance. On a pure forecasting basis, it seems that knowing that a record-breaking skyscraper was built in the previous calendar year can significantly increase the odds of a correct recession forecast.
One substantial caveat to this result: Here, skyscrapers were used to predict the existence of a recession—not the onset of a recession. If we attempted to forecast the onset of a recession, we would again run into a possible small sample problem, as there have only been 26 recessions (and therefore 26 first months of recessions) in that time. Preliminary work using a “first month of a recession” dummy suggests a positive, but not statistically significant, relationship between skyscraper construction in the previous calendar year and the first month of a recession. However, the small sample size suggests that the insignificance could be driven by this test simply being underpowered. That is, even if the relationship exists statistically, the sample size is too small to provide the degree of confidence needed to establish that relationship.
A second caution: there is obviously substantial autocorrelation in the dummy variables. Obviously, February in a calendar year in which a skyscraper is completed follows January of that same year. Also, months in which there are recessions tend to be followed by months in which there are recessions. As a result, some of the strength of this relationship may be the result of autocorrelation. To get around this problem, we performed a very rough Granger-causality-style test using the dummy variables. These are the results:
Recessiont = 0.0199 + 0.0478 Skyscraper Dummyt-12 + 0.9048 Recessiont-1
(3.5658) (3.3215) (84.0972)
Numbers in parentheses are t-statistics from the regression. So, while the economic significance of the skyscraper dummy is diminished once recession inertia is accounted for, the skyscraper dummy does show a positive and statistically significant impact on the odds of a recession. This result is held up against that of Barr et al. (2015), where they showed that height does not Granger-cause output. Here, we show that the building of a record-breaking skyscraper does Granger-cause recessions. How do we reconcile these two results? Simply put: Barr et al.’s results are affected by all construction—not only record-breaking skyscraper construction—and are also impacted by the severity of the business cycle. Ours only considers record-breaking skyscraper construction and the existence of a recession—regardless of its severity. If we believe that height generally increases over the business cycle, but that record-breaking skyscrapers precede crises, then a Barr et al (2015) style analysis will find almost no Granger-causality—as the years in which record-breaking height does predict a downturn will be counterbalanced by the (more common) years in which height is gradually increasing over the course of a boom (or decreasing through a recession).
Once we set aside demands for a precise statistical relationship, however, we can see a great deal of agreement between the papers dealing with the Skyscraper Curse. This relationship can even be found by loosening the relationship that is being considered. For the most part, skyscraper building can be understood as profit-maximizing—and the profit-maximizing height increases during economic booms. This does not deny the possibility that economic booms may induce psychological motives other than profit—like ego and height competition—to increase the height of buildings.
CONCLUSIONThe debate surrounding the Skyscraper Curse has raged around two issues. First, there is substantial theoretical disagreement regarding the underlying causes of the Curse which reflect the underlying theory of construction. Some (Lawrence (1999), Thornton (2005), Engelhardt (2015), Barr et al. (2015)) present skyscraper construction as being primarily a profit-maximizing enterprise. Thus, the Skyscraper Curse would arise if economic conditions arose which simultaneously made skyscraper construction profitable and sowed the seeds of an unsustainable boom. Others (Loeffler [2011], Barr [2012, 2013]) allow more room for psychological factors in skyscraper construction. In this case, the Skyscraper Curse would arise if the same psychological factors that lead to overvaluation in asset markets also lead to skyscraper construction.
Second, there is the question whether something like the Skyscraper Curse exists empirically. That is: can skyscraper construction be used for economic forecasting? Lawrence (1999), Thornton (2005, 2014), and Loeffler (2011) all suggest that the answer is yes. Barr et al. (2015) suggest that the answer is no. Rather than building height predicting output, output predicts height. We provide new evidence that, by sacrificing a certain degree of precision (regarding the depth of recessions), the completion of record-breaking skyscrapers do predict recessions one year later—though the test used here does not distinguish between the onset or the continuance of a recession.
The debates surrounding the Skyscraper Curse draws out an important fundamental point: forecasting turns in the business cycle is—and will continue to be—art as much as science. There will always be a role for entrepreneurial judgment. However, having an understanding of the underlying theory allows one to interpret the signs that surround us. Included among these signs: skyscrapers, which serve all at once as a monument to the successes of the past and as a harbinger of the suffering that is to come.
REFERENCESAli, Mir M. and Kyoung Sun Moon. 2007. “Structural Developments in Tall Buildings: Current Trends and Future Prospects,” Architectural Science Review 50, no. 3: 205–223.
Ames, Nick. 2015. “Elevator Installation Prep Begins at Kingdom Tower,” ConstructionWeekOnline.com, May 10th. Available at http://www.constructionweekonline.com/article-33617-elevator-installation-prep-begins-at-kingdom-tower/
Barr, Jason. 2010. “Skyscrapers and the Skyline: Manhattan, 1865–2004.” Real Estate Economics, no. 38: 567–597.
Barr, Jason. 2012. “Skyscraper Height.” Journal of Real Estate Finance and Economics, no. 45: 723–753.
Barr, Jason. 2013. “Skyscrapers and Skylines: New York and Chicago, 1885–2007.” Journal of Regional Science, no. 53: 369–391.
Barr, Jason, Bruce Mizarach and Kusam Mundra. 2015. “Skyscraper Height and the Business Cycle: Separating Myth from Reality,” Applied Economics 47, no. 2: 148–160.
Bhatia, Neha. 2015. “Soaring Upwards,” ConstructionWeekOnline.com, May 16. Available at http://www.constructionweekonline.com/article-33675-soaring-upwards/
Capozza, Dennis and Yuming Li. 1994. “The Intensity and Timing of Investment: The Case of Land,” American Economic Review 84, no. 4: 889–904.
Chau, K.W., S.K. Wong, Y. Yau, and A.K.C. Cheung. 2006. “Determining Optimal Building Height.” Urban Studies 44, no. 12: 591–607.
Economist. 2015. “Is There Such a Thing as the Skyscraper Curse? March 28.
Engelhardt, Lucas. 2015. “Why Skyscrapers? A Spatial Economic Approach.” Working paper.
Engelhardt, Lucas and Mark Thornton. 2015. “Skyscraper Height and the Business Cycle: Separating Myth from Reality, A Comment,” Mises Working Paper.
Glaeser, Edward. 2013. “A Nation of Gamblers: Real Estate Speculation and American History.” NBER working papers.
Harford, Jarrad. 2005. “What Drives Merger Waves?” Journal of Financial Economics 77, no. 3: 529–560.
Helsley, Robert and William Strange. 2008. “A Game-Theoretic Analysis of Skyscrapers,” Journal of Urban Economics 64, no. 1: 49–64.
Kaza, Greg. 2010. “Note: Wolverines, Razorbacks, and Skyscrapers.” Quarterly Journal of Austrian Economics 13, no. 4: 74–79.
Lawrence, Andrew. 1999. “The Curse Bites: Skyscraper Index Strikes.” Property Report, Dresdner Kelinwort Benson Research.
Loeffler, Gunter. 2011. “Tower Building and Stock Market Returns.” Working paper.
Thornton, Mark. 2005. “Skyscrapers and Business Cycles.” Quarterly Journal of Austrian Economics 8, no. 1: 51–74.
——. 2014. “The Federal Reserve’s Housing Bubble and the Skyscraper Curse.” In David Howden and Joseph T. Salerno, eds., The Fed at One Hundred: A Critical Review on the Federal Reserve System. New York: Springer.
Quarterly Journal of Austrian Economics 19, no. 2 (Summer 2016)ABSTRACT: There is an emerging literature on the subject of skyscrapers and business cycles. Lawrence (1999) first noticed the correlation between important changes in the economy and the building of record-breaking skyscrapers. Thornton (2005) established a theoretical link between the two phenomena. Several papers have subsequently examined the impact of skyscraper building on the economy and in particular on the role of psychological factors on the building of record-breaking skyscrapers. Not surprisingly, most people scoff at this notion, and Barr et al. (2015) present extensive empirical evidence that skyscrapers do not cause changes in GDP, but precisely the opposite. Here we show what the skyscraper curse actually is, and show that the entire empirical literature on this subject supports the existence of a skyscraper curse, including most of Barr et al. (2015). In addition, we present new empirical evidence supporting the skyscraper curse.
KEYWORDS: Skyscraper Curse, business cycle, Austrian SchoolJEL CLASSIFICATION: B53, E32, E37, R11
Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 101–111
[The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression by Scott Sumner]
The Midas Paradox is an impressive piece of scholarship, representing the magnum opus of economist Scott Sumner. What makes the book so unique is Sumner’s use of real-time financial data and press accounts in order to explain not just broad issues—such as, “What caused the Great Depression?”—but to offer commentary on the precise zigs-and-zags of the economy during the 1930s.
Sumner rejects the standard Friedmanite monetarist “long and variable lags” approach, and argues that financial markets respond virtually instantly to new information, including announcements and events that would change expectations about the future path of monetary policy. Both because of his methodological innovations and his painstaking research, Sumner’s book is an invaluable resource to economists and historians interested in the Great Depression and the operation of the classical gold standard.
Although I admire much of the book, I must reject its central thesis. Indeed, the very title The Midas Paradox is an allusion to the disaster that comes from an obsession with gold. Sumner agrees with standard Austrian critiques of the New Deal and its crippling effects on labor markets, but he also thinks a large portion of the blame for the Great Depression lies with the unfortunate fact that policymakers’ hands (and currencies) were tied to gold. Even though economists back in the 1930s thought that central banks were “pushing on a string” with their low interest rate policies, Sumner thinks it is now well established that it was unwittingly tight money that made this depression “Great.”
Furthermore, Sumner draws lessons for today, believing that economists are wrong to focus on low nominal interest rates and even the huge expansions in monetary bases that the world’s major central banks have delivered since the 2008 crash. Instead, with his “Market Monetarist” framework, Sumner believes that central banks have foisted enormously tight monetary policy on the world, and that this largely explains the horrible crash and then sluggish recoveries of Western nations in the last decade.
In Sumner’s view, only by adopting a more useful criterion for assessing monetary policy can economists explain past crises and help policymakers avoid future ones. As Sumner concludes his introductory chapter: “The events of the past five years should make us all a bit more forgiving of those interwar policy experts who failed to correctly diagnose the problem in real time. When aggregate demand collapses, it looks to almost everyone as if the symptoms of the fall in aggregate demand are the causes. That was true in the 1930s and it is equally true today” (p. 32).
Although I could spend the rest of this review noting the areas on which I agree with Sumner, the best contribution I can make is to point out why I think his thesis ultimately fails. To that end, I will first show that the single most important relationship he charts in the book—and it is Sumner himself who christens it as such—is just as consistent with the Rothbardian (1963) explanation of the Depression as it is with a Market Monetarist one. Then I will show that Sumner’s emphasis on gold—which is the reason for the book’s title, after all—is misplaced; it cannot fulfill the criterion that Sumner himself says it must.
I will conclude that Sumner’s book, excellent though it is in many respects, fails in its purpose. Austrians who subscribe to the Rothbardian explanation (which in turn was an elaboration of the Misesian theory of the business cycle) may collect some interesting nuances and a wealth of data from Sumner’s book, but they have no reason to abandon their basic framework.
Evidence that Fits Both Frameworks: The Connection between Real Wages and OutputIn his introductory chapter Sumner declares, “If I were asked to give a talk on the Great Depression and allowed just one slide, it would undoubtedly be Figure 1.2” (p. 20). We have reproduced that crucial chart below.
Figure 1.2: The Relationship between Detrended Industrial Production and Detrended (Inverted) Real Wages, 1929–1939, MonthlyIn Sumner’s figure, the gray line shows the logarithm of industrial production, meaning that straight lines indicate steady percentage rates of growth (or shrinkage). The dark black line is the logarithm of the inverse of the real (i.e. price-level-adjusted) wage rate.
The figure shows quite clearly that during the 1930s, as real wages increased, industrial production fell. On the other hand, increases in industrial production went hand-in-hand with declines in real wages.
As it happens, I am perfectly happy with Sumner’s graph. In fact, I will go further and enthusiastically endorse just about all of Sumner’s interpretation of it as well:
[A] sharp fall in output could be caused by either a rise in nominal wages or a fall in the price level. It so happens that both factors played an important role in the Great Depression….
During the 1930s, the biggest supply shocks were New Deal programs aimed at artificially raising nominal wages. There were five big wage shocks, each of which tended to abort otherwise promising recoveries in industrial production. These wage shocks thus tended to make real wages more countercyclical—higher wages led to lower output.
…
But what about the demand shocks, which were the major cause of the Great Contraction? Recall that the real wage is the nominal wage divided by the price level…. Wholesale prices fell sharply during the 1929–1933 and 1937–38 contractions and rose sharply after the dollar was devalued in April 1933. Because nominal wages tend to be sticky, or slow to adjust, sudden changes in the WPI tend to show up inversely as changes in the real wage rate…. If prices fall much faster than wages, then profits decline and companies lay off workers. Real wages actually rose sharply during the early 1930s for those lucky enough to maintain full-time jobs. (Sumner, pp. 20–22, emphasis added.)
Perhaps surprisingly, in the above quotation, Sumner has provided the same basic explanation of the high (and persistent) unemployment rate that I myself gave, in my decidedly Rothbardian treatment in Murphy (2009). Sumner and I agree that during the 1930s, unemployment shot up whenever real wages were increasing and (perversely) made labor more expensive relative to other commodities.
However, where Sumner and I disagree concerns the blame for this state of affairs. If the general price level falls, while nominal wage rates do not fall nearly as much, then Sumner ultimately blames the monetary authorities for letting the purchasing power of money increase so rapidly. In contrast, I blame the other interventions of the federal government (in conjunction with labor unions) for making wages so much “stickier” than they had been in previous depressions.
In particular, we can compare the behavior of nominal wages and prices of the early 1930s with the experience from the 1920–1921 depression. Here we rely on the statistics and analysis from Gallaway and Vedder (1987). First we reproduce one of their tables:
Table 4: Rate and Indexes of Consumer Prices, Money Wages, Productivity, and Productivity-Adjusted Real WagesAs the final column from the table shows, real wages for hourly workers—especially if we further factor in productivity—grew substantially over the years of the Great Contraction, reaching almost 20 percent higher by 1933 (when the unemployment rate was almost 25 percent). For another amazing fact, note that nominal (money) wage rates for hourly workers in 1931 were only 5.6 percent lower than they had been in 1929, even though consumer prices by that point had fallen 11.4 percent. During this year, unemployment was already at a devastating 15.9 percent.
Even the table above does not shed light on the policies that might have contributed to the problem. After all, Sumner could take these data from Gallaway and Vedder in stride, showing the disastrous consequences of the Fed’s (allegedly) tight monetary stance in the early 1930s amidst “sticky nominal wages.”
Yet here is where the comparison with the 1920–1921 episode is decisive. After producing the above table, Gallaway and Vedder explain:
The issue is whether the Hoover recipe delayed the onset of money wage adjustments sufficiently to exacerbate the disequlibrium and increase the severity of the Great Depression. The evidence is persuasive that this is the case…. [A] monthly wage index compiled by the Federal Reserve Bank of New York (reported by Lionel Robbins) shows almost no movement in money wage rates from the fourth quarter of 1929 through the second quarter of 1930.
Contrast this pattern with that of the 1920–21 downturn. In both cycles, industrial production peaked at midsummer before the onset of the decline. In both cycles, the decline was precipitous, 27.5 percent from July 1920 to July 1921 and 21.3 percent from June 1929 to July 1930. However, as noted earlier, in the 1920-21 case, money wage rates fell by 13 percent, setting the stage for the sharp recovery that began in August 1921. One of the factors cited by Benjamin Anderson in explaining this recovery is “a drastic reduction in the costs of production.” How these costs were reduced is clear—money wage rates were cut, something that did not occur in the early days of the Great Depression. For example, according to data compiled by the National Industrial Conference Board, hourly wage rates for unskilled male labor fell more between 1920 and 1921 than they declined throughout the Great Depression.
The clear implication seems to be that the money wage rate adjustment process was distinctly different during the Great Depression compared to the 1920–21 decline in business activity. Apparently, Herbert Hoover’s goal of maintaining levels of money wage rates was achieved, at least temporarily. (Gallaway and Vedder, 1987, p. 46, emphasis added, endnotes removed.)
Much more recently, Lee Ohanian (2009) develops a formal neoclassical model and concludes that Herbert Hoover’s policies—which asked large firms to maintain nominal wage rates in exchange for keeping out unions—are ultimately to blame for the Great Depression. He writes in his abstract: “The theory also can reconcile why deflation/low nominal spending apparently had such large real effects during the 1930s, but not during other periods of significant deflation.”
In summary, regarding the “one slide” that Sumner would use if he had to choose just one, he and I are in agreement: The key to understanding the massive unemployment of the 1930s is real wage rates. Sumner and I agree that during an economic downturn, the last thing in the world we want is for labor to become artificially more expensive as prices fall faster than wage rates.
Yet rather than ask (ask Sumner does) why policymakers at the Federal Reserve allowed such a deadly fall in prices, instead I would ask why policymakers in the federal government hindered the fall in (nominal) wages that had been the norm in previous depressions (or “panics”).
Sumner's Misplaced Emphasis on GoldIn the previous section, I argued that the Rothbardian interpretation of the Great Depression could easily incorporate the single most important graphical relationship of Sumner’s book. Namely, a Rothbardian could agree that the immediate driver of unemployment was the real wage rate, but the Rothbardian would lay the blame on government measures that interfered with nominal wage adjustments, rather than with deflationary monetary policy.
In this section, I question Sumner’s emphasis on money—and in particular, the operation of the gold standard—as a key component of the Great Depression. Here again we will reproduce a key chart from Sumner’s book, namely Figure 2.1 (p. 44), which plots the inverse of the “gold ratio” against industrial production:
Figure 2.1: Industrial Production and 12-Month Change in C/G RatioTo understand the significance of this figure, we first must explain the “inverted gold ratio.” Sumner had earlier (p. 28) defined the gold reserve ratio as “the ratio of the monetary gold stock and the currency stock.” Now under the rules of the classical gold standard, “countries were supposed to adjust their currency stock in proportion to their changes in their monetary gold stock,” and thus if a country did not do so, then such “[v]ariations in the gold reserve ratio can be seen as an indicator of discretionary monetary policy” (p. 29).
Returning to the figure above, we now see how it apparently endorses the Sumnerian framework. If the currency/gold ratio (the dark black line) falls, it means that the outstanding stock of currency has fallen relative to the amount of gold held for monetary purposes. It is discretionary monetary policy tightening, in the context of the classical gold standard. And since the dark black line goes hand-in-hand with industrial production (the gray line), Sumner believes that this chart is consistent with his central thesis.
However, even at this stage, there are problems. First, note that from January 1929 up until the fateful month of October 1929, the 12-month change in the currency/gold ratio is (slightly) negative. Even so, industrial output rises through the summer. Moreover, the particular zigs and zags do not coincide with each other; there is a relative tightening (i.e. falling dark black line) from April through June, while industrial production rises during this stretch. Furthermore, there is a spike in the black line going into October 1929, which (to repeat) represents a relative loosening of monetary policy in Sumner’s framework.
To be sure, eventually both lines collapse, but it is hardly clear that the movements in the black line are causing reactions in the gray line. Indeed, consider that as of January 1930, the height of the black line has returned to the same position it held back in April 1929. That means that the (modest) 12-month decline in the inverted gold ratio by January 1930 was no larger than that same change had been in April 1929. And yet, this monetary tightening coincided with growing industrial output back in April, while by January industrial production was in free-fall.
Now, when it comes to explaining the stock market crash of October 1929, what really matters is not the mechanical policy of that moment but rather the expectations of investors. Perhaps the Federal Reserve signaled in some way the sharp tightening of monetary policy that would eventually come, and investors realized how much things had changed as fall 1929 unfolded.
As a staunch proponent of the Efficient Market Hypothesis (EMH), this is indeed the approach Sumner adopts. Space constraints do not allow me to summarize his case, but I think it is fair to say that he presents no smoking guns. In fact, Sumner himself implicitly admits that he has failed in the task he set for himself, when he (no doubt subconsciously) moves the goalposts.
Specifically, on page 40 Sumner tells us his strategy (consistent with the EMH):
Before we throw up our hands and accept the “bubble” explanation, we should first see whether there is an alternative explanation that allows for sensible investors to have been highly optimistic in September 1929 and much more pessimistic in November 1929. (Sumner, p. 40, emphasis added.)
To reiterate, for Sumner’s book to “work,” he must now show us what tangible actions (which could have been in the form of remarks made to the press) the Federal Reserve made in a two-month window from September to October 1929, which involved the handling of the gold standard and which made both the stock market valuations of early September and late October 1929 “rational.” Were there any such actions that would have altered expectations in such a drastic way?
I submit that Sumner gives us nothing that fits the bill. He himself seems to acknowledge this when, twenty-one (unconvincing) pages later, Sumner writes:
At the beginning of this chapter, I suggested that in order to understand the October [1929] crash, one needed to explain why it would have been sensible for investors to be highly optimistic in September 1929, and somewhat pessimistic in November 1929. Is there an explanation for such a dramatic change in sentiment? (Sumner, pp. 60–61, emphasis added.)
Note the subtle movement of the goalposts (again, I believe innocent enough); on page 40 he had sought something that would make investors “much more pessimistic” two months later, while on page 61 he has lowered the bar to “somewhat pessimistic.” (Would a mere change to “somewhat pessimistic” explain back-to-back drops of almost 13 percent and then 12 percent, which is what happened in the market on October 28 and 29?) Sumner knows he doesn’t have it. Indeed, later on this page Sumner writes, “This makes it almost impossible to establish a clear link between monetary policy and the 1929 crash” (p. 61).
Now in fairness, Sumner might respond that his book does not need to explain how monetary tightening—due to the constraints of the gold standard—led to the 1929 stock market crash. This is because one of the ways Sumner departs from conventional analyses is that he thinks market crashes do not necessarily coincide with “real” downturns; his best counterexample is the 1987 market crash, which was bigger than the 1929 one and obviously didn’t spawn a decade-long depression.
Even so, it sure seems as if the 1929 stock market crash had an awful lot to do with the onset of the Great Depression. Just look again at the final chart above, taken from Sumner: the big drop in industrial production clearly began with the market crash. The fact that Sumner admits his framework can’t really explain this sharp turnaround is (in my opinion) key evidence that his focus on gold—and denial of the existence of asset bubbles—is fundamentally mistaken.
ConclusionIn truth, no economic historian can explain the precise timing of every movement in the financial markets and broader economy, for the simple reason that humans have free will. Even so, using the very criteria Sumner himself embraces, we can conclude that his book—though superb in several dimensions—does not achieve its stated purpose.
Putting aside the detailed statistics, I will end this review with a simple question: How can it be that the classical gold standard is largely responsible for the Great Depression, when the classical gold standard was operating during several previous financial panics and depressions (small “d”)? To blame the Great Depression on the gold standard is akin to blaming a particular plane crash on gravity.
In contrast, the Rothbardian analysis at least has a shot at being satisfactory. After all, Herbert Hoover in his memoirs tried to defend his legacy by assuring his readers (truthfully) that his administration had taken unprecedented measures in battling the Depression, meddling in the economy in ways that no president during peacetime had done before. That’s the place to start, when we ponder why Herbert Hoover suffered from a worse downturn than any president before.
Quarterly Journal of Austrian Economics 18, no. 4 (Winter 2015)
ABSTRACT: The paper aims to defend the general validity of the ABCT against the assumption that the theory does not hold if entrepreneurs are able to anticipate correctly the inflationary effects of a fiduciary credit expansion. Hülsmann (1998) raises this critique and puts forward a general theory of error cycles centered on government intervention in the economy in order to overcome the perceived shortcomings of the traditional ABCT. The paper analyzes the main implications of this critique of the ABCT in terms of entrepreneurial foresight and the optimal course of action necessary to prevent a monetary induced business cycle, in particular in the context of fractional reserve banks operating under fiat currency. It concludes that within the general framework of human action, entre-preneurs cannot arbitrage away clusters of errors, and the ABCT remains valid. This paper also questions whether Hülsmann’s essentialist approach can be a viable alternative to the traditional ABCT, and find that, despite its merits, the approach can be refuted as a stand-alone theory.
KEYWORDS: business fluctuations, credit and money multipliers, interest rate, rational expectations, government interventionJEL CLASSIFICATION: E32, E51, E43, E03, P00
Quarterly Journal of Austrian Economics 18, no. 3 (Fall 2015)ABSTRACT: The aim of the article is to refine the Austrian business cycle theory by discussing the effect of changes in banks’ asset structure on the business cycle. I disaggregate the process of credit expansion in the spirit of Cantillon’s dynamic analysis of how the new money enters the economy, pointing out that banks can conduct the credit expansion not only by granting loans, but also by purchasing investment securities. I examine distinct results of those two methods and differences resulting from the type of purchased security or granted loans (the so-called secondary effects of business cycle). Based on my analysis, I propose a preliminary classification of business cycles.
KEYWORDS: Austrian business cycle theory, bank’s asset structure, Cantillon effect, credit expansion, secondary effects of business cycleJEL CLASSIFICATION: B53, E32, E44, E51, G21, N12
Quarterly Journal of Austrian Economics 18, no. 2 (Summer 2105)The Smoot-Hawley Tariff Act of 1930 could be the best-known piece of Congressional legislation. It also remains among the most controversial; both vilified and embraced by politicians of all stripes to further their cause, whether that be increasingly protectionist trade measures or an expansion of unencumbered free trade. Over the course of four succinct chapters, Dartmouth economics professor Douglas Irwin expertly separates the wheat from the chaff of this oft-misunderstood Act to give life to its evolution, as well as its role in deepening the Great Depression.
Quarterly Journal of Austrian Economics 18, Number 2 (Summer 2105)Murray Rothbard told us that liberty is what allows human flourishing, that liberty requires private property rights and the non aggression principle (NAP), and that this nation was conceived in liberty.
What do mainstream economists tell us today? I attended a seminar in my department a few weeks ago. As everyone walked into the room, the presenter had an equation showing on a powerpoint slide via a projector. Before really getting started, a lively discussion began—all about whether the function should be Cobb-Douglas or CES and whether the data were aggregated in one way or another and whether this or that parameter should be present. This is what passes for economics these days in mainstream departments. ...
Murray N. Rothbard Memorial LectureAustrian Economics Research ConferenceLudwig von Mises InstituteAuburn, AlabamaMarch 12, 2015
Quarterly Journal of Austrian Economics 18, no. 2 (Summer 2015)Symposium: Is There A Missing Element in Economics?
My first introduction to Austrian Economics came when I borrowed the well-thumbed copy of Ludwig von Mises’s Human Action from my boss, then-Congressman Jack Kemp, for whom I worked as speechwriter and congressional staff economist before and during both presidential administrations of Ronald Reagan. While I have a high regard for what Austrian economics gets right that other economic schools do not, I consider myself a “Neo-Scholastic” economist, a term which I will try to explain.
The Lou Church Memorial Lecture in Religion and EconomicsAustrian Economics Research ConferenceLudwig von Mises InstituteAuburn, AlabamaMarch 12, 2015
Asset price inflation, a disease whose source always lies in monetary disorder, is not a new affliction. It was virtually inevitable that the present wild experimentation by the Federal Reserve — joined by the Bank of Japan and ECB — would produce a severe outbreak. And indications from the markets are that the disease is in a late phase, though still short of the final deadly stage characterized by pervasive falls in asset markets, sometimes financial panic, and the onset of recession.
Global Signs of DangerA key sign of danger, recognizable from historical patterns of how the disease progresses, is the combination of steep speculative temperature falls in some markets, with still-high — and in some cases, soaring — temperatures in other markets. Another sign is some pull-back in the carry trade, featuring, in particular, the uncovered arbitrage between a low (or zero) interest rate, and higher rate currencies. For now, however, this is still booming in some areas of the global market-place.
Specifically, we now observe steep falls in commodity markets (also in commodity currencies and mining equities) which were the original area of the global market-place where the QE-asset price inflation disease attacked (back in 2009–11).
Previously hot real estate markets in emerging market economies (especially China and Brazil) have cooled at least to a moderate extent. Most emerging market currencies — with the key exception of the Chinese yuan — once the darling of the carry traders, are in ugly bear markets. The Shanghai equity market bubble has burst.
Yet in large areas of the high-yield credit markets (including in particular the so-called covenant-lite paper issued by highly leveraged corporations) speculative temperatures remain at scorching levels. Meanwhile, Silicon Valley equities (both in the public and private markets), and private equity funds enjoy fantasy valuations. Ten-year Spanish and Italian government bond yields are hovering below 2 percent, and hot spots in global advanced-economy real estate — whether San Francisco, Sydney, or Vancouver — just seem to get hotter, even though we should qualify these last two observations by noting the slump in the Canadian and Australian dollars. Also, there is tentative evidence that London high-end real estate is weakening somewhat.
How to Identify Late Stages of Asset InflationWe can identify similar late phases of asset price inflation characterized by highly divergent speculative temperatures across markets in past episodes of the disease. In 1927–28, steep drops of speculative temperature in Florida real estate, the Berlin stock market, and then more generally in US real estate, occurred at the same time as speculative temperatures continued to soar in the US equity market. In the late 1980s, a crash in Wall Street equities (October 1987) did not mark the end-stage of asset price inflation but a late phase of the disease which featured still-rising speculation in real estate and high-yield credits.
In the next episode of asset price inflation (the mid-late 1990s), the Asian currency and debt crisis in 1997, and the bursting of the Russian debt bubble the following year, accompanied still rising speculation in equities culminating in the Nasdaq bubble. In the episode of the mid-2000s, the first quakes in the credit markets during summer 2007 did not prevent a further build-up of speculation in equity markets and a soaring of speculative temperatures in winter 2007–08 and spring 2008 in commodity markets, especially oil.
What insights can we gain from the identification of the QE-asset price inflation disease as being in a late phase?
The skeptics would say not much. Each episode is highly distinct and the disease can “progress” in very different ways. Any prediction as to the next stage and its severity has much more to do with intuition than scientific observation. Indeed some critics go as far as to suggest that diagnosis and prognosis of this disease is so difficult that we should not even list it as such. Historically, such critics have ranged from Milton Friedman and Anna Schwartz (who do not even mention the disease in their epic monetary history of the US), to Alan Greenspan and Ben Bernanke who claimed throughout their years in power — and these included three virulent attacks of asset price inflation originating in the Federal Reserve — that it was futile to try to diagnose bubbles.
We Can’t Ignore the Problem Just Because It’s Hard to MeasureDifficulties in diagnosis though do not mean that the disease is phantom or safely ignored as just a minor nuisance. That observation holds as much in the field of economics as medicine. And indeed there may be a reliable way in which to prevent the disease from emerging in the first place. The critics do not engage with those who argue that the free society’s best defense against the asset price inflation disease is to follow John Stuart Mill’s prescription of making sure that “the monkey wrench does not get into the machinery of money.”
Instead, the practitioners of “positive economics” demonstrate an aversion to analyzing a disease which cannot be readily identified by scientific measurement. Yes, the disease corrupts market signals, but by how much, where, and in what time sequence? Some empiricists might acknowledge the defining characteristic of the disease as “where monetary disequilibrium empowers forces of irrationality in global markets.” They might agree that flawed mental processes as described by the behavioral finance theorists become apparent at such times. But they despair at the lack of testable propositions.
Mis-Measuring Increases in Asset PricesThe critics who reject the usefulness of studying asset price inflation have no such qualms with respect to its twin disease — goods and services inflation. After all, we can depend on the official statisticians!
In the present monetary inflation, a cumulative large decline in equilibrium real wages across much of the labor market, together with state of the art “hedonic accounting” (adjusting prices downward to take account of quality improvements) has meant that the official CPI has climbed by “only” 11 percent since the peak of the last business cycle (December 2007). The severity of the asset price inflation disease makes it implausible that the official statisticians are measuring correctly the force of monetary inflation in goods and services markets.
What Is the Final Stage?A progression of the asset price inflation disease into its final stage (general speculative bust and recession) would mean the end of monetary inflation and also inflation in goods and services markets. What could bring about this transition? Most plausibly it will be a splintering of rose-colored spectacles worn by investors in the still hot speculative markets rather than Janet Yellen’s much heralded “lift-off” (raising official short-term rates from zero). What could cause the splinter?
Perhaps it will be a sudden rush for the exit in the high-yield credit markets, provoked by alarm at losses on energy-related and emerging market paper. Or financial system stress could jump in consequence of the steep falls of speculative temperature already occurring (including China and commodities). Perhaps there will be a run from those European banks and credit funds which are up to their neck in Spanish and Italian government bonds. Or the Chinese currency could tumble as Beijing pulls back its support and the one trillion US dollar carry trade into the People’s Republic implodes. Perhaps scandal and shock, accompanied by economic disappointment will break the fantasy spell regarding US corporate earnings, especially in Silicon Valley. As the late French President Mitterrand used to say, “give time to Time!”
October 30, 1929. A brisk autumn’s day in Manhattan. The Savoy-Plaza Hotel’s thirty-three stories cast a long shadow over Central Park. At the base of the hotel a financier lies freshly fallen, motionless, while his last breath, wrenched from the lungs by force of impact, is now a red mist of gore in the air.
Sirens and uniforms. The suicide spot quickly becomes crowded by spectators, who form a vision-impairing ring-fence of backs, much to the annoyance of elbow-throwers at the periphery. Winston Churchill stands at his hotel window looking down on the mess. To nobody’s surprise, the police will find an empty wallet and five margin calls in the dead man's pockets.This is a dramatization of an event reported by Winston Churchill. Quoted on p. 7 of Robert P. Murphy’s Politically Incorrect Guide To The Great Depression and the New Deal.
Churchill’s curtains flutter shut, and we are left to wonder whether anyone — Churchill included — can yet see his clumsy, cigar-wielding hand in it all; whether anyone realizes that, had Churchill as Chancellor of the Exchequer only restored the gold standard at a lower exchange rate, as Keynes had recommended, the Wall Street Crash of 1929 could have been averted (or at least ameliorated).
Alas, by ignoring Keynes in 1925, Churchill triggered a calamity so severe that it not only inspired one man to kill himself beneath the British statesman’s very window but, more insidiously, also provided the impetus for the economics profession’s rejection of the “classical” axioms. As Keynes’s biographer Robert Skidelsky writes, Keynes “did not believe in the system of the ideas by which economists lived; he did not worship at the temple.” And while “in former times he would have been forced to recant, perhaps burnt at the stake, as it was ... the exigencies of his times enabled him to force himself on his church.”
1925: Britain’s Return to the Gold StandardThe pound sterling’s link to gold was severed at the start of WWI. After eleven years of unfettered inflation, Chancellor of the Exchequer Winston Churchill restored convertibility at the pre-war level of 4.25 pounds per ounce of gold.
Keynes, quite rightly, took exception to this particular detail: expecting Britain’s global customers to go on paying the same gold-price for the weakened pound was unrealistic. At this exchange rate the pound would be overvalued, and the only cure would be a sustained period of deflation — which was “certain to involve unemployment and industrial disputes.” Indeed, in 1926 a general strike crippled Britain for nine days.
What Keynes did not predict, however, was how Churchill’s blunder would later bring about an easing of monetary policy in America. And even supposing Keynes had predicted this side effect, would he have understood its implications for long-run sustainability? (Recall that both F.A. Hayek and Keynes predicted a crash would occur in 1929: Hayek because interest rates were too low, Keynes because they were too high!)
1927: At the Fed (With Cap in Hand)American sellers (in particular) were accepting British gold in exchange for goods, but were dissuaded from returning it due to the unfavorable rate of exchange. As a result, Britain’s gold supplies diminished at a rapid rate, which made the authorities understandably twitchy: how could they keep their pledge to convert pounds into gold if they had none?
In response, the Governor of the Bank of England, Montagu Norman, set off across the Atlantic and, with much pleading, persuaded the Federal Reserve to ease monetary policy. By lowering interest rates and raising inflation, the Fed stemmed gold flows into America, giving the British a much-needed respite from the ill-effects of Churchill’s costly pound.
With this episode of soft-hearted internationalism came an upswing in the Wall Street boom and “from that date,” wrote Lionel Robbins, “according to all the evidence, the situation got completely out of control.”
In The Great Crash, a very popular account of the lead up to the Great Depression, John Kenneth Galbraith writes:
the rediscount rate of the New York Federal Reserve was cut from 4 to 3.5 percent. Government securities were purchased in considerable volume with the mathematical consequence of leaving the banks and individuals who had sold them with money to spare. The funds that the Federal Reserve made available were either invested in common stocks or ... they became available to help finance the purchase of common stocks by others. So provided with funds, people rushed into the market.
Galbraith goes on to quote a member of the Federal Reserve Board who, with hindsight, called the operation “one of the most costly errors” committed by a banking system “in 75 years.”
Galbraith finishes: “the view that the action of the Federal Reserve in 1927 was responsible for the speculation and collapse which followed has never been seriously shaken.”
John Maynard Who?When Keynes wrote against returning to the gold standard at pre-war parity in 1925, he did so with the expectation that he might actually influence policy. As a younger, unknown man he had worked at the Treasury for a brief stint, leaving a legendary impression; and by 1925, six years after his best-seller The Economic Consequences of the Peace, he was a famous man whose words carried weight.
It is not outlandish then to imagine a world in which Keynes got his way. In such a world, the Wall Street crash and ensuing depression might never have happened — without the costly pound, the Fed would have had no impetus to inflate. Keynes would subsequently have found the economics profession less rattled, less willing to abandon its “classical” axioms in favor of his new-fangled approach. Keynes might have averted Keynesianism.
In a dynamic economy, an action not only triggers just one effect, but always an entire series of different consequences. While the cause of the first effect is easily recognizable, the other effects often occur only later and no such recognition occurs. Frédéric Bastiat described this phenomenon in 1850 in his ground-breaking essay “What Is Seen and What is Not Seen”:
In the economic sphere, an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them …
There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen. Yet this difference is tremendous; for it is almost always the case that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Hence it follows that the bad economist pursues a small present good that will be followed by a great evil, while the good economist pursues a great good to come, at the risk of a small present evil.
A similar phenomenon can be seen with the consequences of artificially suppressed interest rates and monetary stimulus: in the short term, they appear to have positive effects, the long term effects are, however, disastrous. If one studies these processes closely, it becomes clear that the underlying problems cannot be solved by global zero-interest-rate policy (ZIRP), but that this instead undermines the natural selection process of the market.
With artificial stimulus like ZIRP, we only end up with a situation in which governments, financial institutions, entrepreneurs, and consumers who should actually be declared insolvent all remain on artificial life support.
In line with Bastiat’s thoughts, numerous fatal long-term consequences of zero-interest-rate policies can be identified, but are generally ignored:
Conservative investors by nature come under increasing pressure with respect to their investments and take on excessive risks in light of the prospect that interest rates will remain low in the long term. This leads to capital misallocation and the emergence of bubbles.The sweet poison of low interest rates leads to massive asset price inflation (stocks, bonds, works of art, real estate).Structurally too low interest rates in industrialized nations due to carry trades lead to the emergence of asset price bubbles and contagion effects in emerging markets.Changes in human behavior patterns occur, due to continually declining purchasing power. While thrift is increasingly mutating into a relic of the past, taking on debt comes to be seen as rational.As a result of the structurally too low level of interest rates, a “culture of instant gratification” is created, which is among other things characterized by the fact that consumption is financed with credit instead of savings. The formation of wealth becomes steadily more difficult.The medium of exchange and unit of account function of money increases in importance, while its role as a store of value declines.Incentives for fiscal discipline decline.Zombie banks are created: Low interest rates prevent the healthy process of creative destruction. Banks are enabled to roll over potentially non-performing loans practically indefinitely and can thus lower their write-off requirements.Newly created money is neither uniformly nor simultaneously distributed amongst the population. This results in a permanent transfer of wealth from later receivers to earlier receivers of newly created money.Conventional monetary policy — that is, the promotion of credit creation by lowering interest rates — reaches its limits once the “zero-bound” is reached. In order to continue the spiral of stimulus, “unconventional monetary policy” becomes ever more important. The multitude of “newfangled” monetary policy measures is seemingly only limited by the imagination of central bankers, whereby recent years have shown that central bankers can be extraordinarily creative. That this phenomenon is nothing new, is inter alia shown by this observation by Ludwig von Mises in 1922:
But an increase in the quantity of money and fiduciary media will not enrich the world. … Expansion of circulation credit does lead to a boom at first, it is true, but sooner or later this boom is bound to crash and bring about a new depression. Only apparent and temporary relief can be won by tricks of banking and currency. In the long run they must lead to an all the more profound catastrophe.
Presented at Mises Boot Camp, a one-day seminar for anyone seeking to learn the fundamentals of the Austrian school. Download the Syllabus.
Recorded at the Mises Institute in Auburn, Alabama, on 25 July 2015.
Volume 18, Number 1 (Spring 2015)ABSTRACT: This brief note points out that Milton Friedman’s “Plucking Model” has not held following the Great Recession. Friedman argued that the Plucking Model offered evidence against theories like Austrian Business Cycle theory; the bust was what needed explanation, not the boom. But as many economists have pointed out, the years leading up to the Great Recession fit many of the stylized predictions of the Austrian Business Cycle. Given their observations, it is of interest that the bust in recent years has not followed the Plucking Model.
KEYWORDS: Austrian Business Cycle, Plucking Model, Great RecessionJEL CLASSIFICATION: B53, E32
Volume 18, Number 1 (Spring 2015)ABSTRACT: The popularity of the Austrian Business Cycle Theory (hereafter ABCT) continues to grow in both the popular press and the mainstream of the economics profession. That the ABCT is increasingly subjected to conventional empirical analysis is a testament to its intuitive appeal. In first-world economies, the agriculture sector is characterized by investment in expensive and highly-specialized equipment. While some agricultural products are “close to consumption,” the network of highly specialized processing and transportation equipment necessary for the functioning of modern agriculture indicates that this sector is characterized by more roundabout production processes. Since the ABCT is primarily a theory of malinvestment in the more roundabout stages of production, analysis of the agricultural sector of the economy is relevant to the study of ABCT. This paper examines data for the production agriculture industry to determine whether business cycles in industry are consistent with the ABCT. Time series analysis using vector autoregression and other methods is conducted. Results are mixed, but strong arguments in favor of ABCT effects in agriculture are made.
KEYWORDS: agriculture, Austrian Business Cycle Theory, VARJEL CLASSIFICATION: Q14, E3, B53
Recorded at the Mises Institute in Auburn, Alabama, on 10 April 2014. Includes an introduction by Jeff Deist.
Super tall buildings, or skyscrapers, are being built at an astonishing rate. Ninety-seven buildings that exceed 200 meters (656 feet) high were constructed in 2014, setting a new record. The previous record was eighty-one buildings completed in 2011. The total number of skyscrapers in existence now is 935, a whopping 350 percent increase since the year 2000.
Another record set in 2014 was the completion of eleven super-tall skyscrapers of over 300 meters or nearly 1,000 feet. That is the distance in height of over three football fields. The tallest skyscraper completed in 2014 was One World Trade Center in New York City. It is the third tallest skyscraper in the world, and the tallest in the western hemisphere, but only if you count the antenna/spire in the building’s height.
The tallest skyscraper in the world is the Burj Khalifa in Dubai, United Arab Emirates. On July 21, 2007 it surpassed the height of the then-reigning record holder Taipei 101.
The Shanghai Tower, which is the tallest skyscraper in China, opens for business in mid-2015. The third tallest is the Makkah Royal Clock Tower in Saudi Arabia.
What is the Skyscraper Curse?The reason all of this is important is the “skyscraper curse.” The curse is based on the correlation between the setting of new record heights in skyscrapers and the onset of economic crisis over the last century, or longer.
The last clear global signal of the curse was the Burj Khalifa, which saw the ruler of Dubai unable to repay the loans for all his elaborate real estate development projects. However, the Shard building in London set a new European record and ushered in the European economic and debt crisis.
Skyscraper Curse watchers have recently returned their attention to the Middle East. According to the Wall Street Journal Dubai’s real estate moguls have embarked on another “Go-Go Era” of boom and bust:
Dubai has slowly but surely clawed its way out of the hole it dug for itself in 2009 when a series of government-linked companies, including several under the direct control of ruler Sheikh Mohammed bin Rashid Al Maktoum, were unable to pay lenders on time and called for a standstill on repayments. The move signaled the death knell for an economic boom that had been fueled by real estate for almost a decade.
Dubai has again succeeded in convincing lenders — both international titans like HSBC and Standard Chartered and dozens of local banks — to support its government-linked real-estate developers. Investors, analysts and the emirate’s new crop of leaders all say this time is different to the previous boom running up to 2009.
Not only is the world teeming with real estate speculation and skyscraper building from China, to New York, to London, and the Middle East, there is a new world record setting skyscraper being constructed in Jeddah, Saudi Arabia. The Kingdom Tower is designed to be over one kilometer in height, or more than eleven football fields. It is to be completed in late 2016 or 2017. As designed, the Kingdom Tower will exceed the height of the Burj Khalifa by more than 500 feet. If events proceed as the skyscraper curse predicts, the beginning of construction of the Kingdom Tower signals a crisis alert (when a new record setter has begun) and will change to a crisis signal (when a new record is set) between now and the end of 2016.
Record-Setting Skyscrapers are Symptoms, Not CausesOf course, the building of record-setting skyscrapers does not cause world economic crisis. The records are merely symptoms of the underlying cause of world economic bubbles: sustained artificially low interest rates by central banks. I explain the process and the theoretical connections between record-setting skyscrapers and world economic crises here in the Quarterly Journal of Austrian Economics.
The skyscrapers can sometimes tell us about the geography of world economic bubbles. The last bubble occurred in the oil rich Middle East and the next one would also seem to be in the Middle East. Both bubbles began when oil prices exceeded $100 a barrel.
It is interesting to note that Prince Alwaleed, the owner of the Kingdom Tower project recently and unexpectedly sold most of his large stake of stock in News Corp, Rupert Murdoch’s media conglomerate, to raise nearly $200 million. The move was said to have been part of an overall review and rebalancing of the Prince’s $20 billion portfolio. This is probably a smart move given the collapse of oil prices and the hefty price tag of $1.25 billion for the Prince’s Kingdom Tower.
Image source: iStockphoto.
Volume 17, No. 4 (Winter 2014)KEYWORDS: John Maynard Keynes, marginal efficiency of capital, net present value, interest rates, central bankingJEL CLASSIFICATION: E12, E22, E52, In his recent article, Edward W. Fuller (2013) compared the Keynesian Marginal Efficiency of Capital approach with the Austrian Net Present Value approach. While his article has some important insights regarding the different treatments of investment projects in these two approaches, the result that the two approaches result in different rankings will only hold if factor prices are held constant. But, as the paper states, such an assumption is generally not true.
To briefly summarize Fuller’s main point: the net present value criterion demonstrates that there is a “switching” from one type of investment project to another as interest rates change. In particular, as interest rates rise, shorter projects will be preferred, while longer projects are preferred when interest rates are lower. In the marginal efficiency of capital approach, there is no such switching. Rather, there is an invariant list of projects with each listed by its rate of return (defined as that interest rate which sets the net present value equal to zero), and the going interest rate acts as a “hurdle” rate, determining how far down the list investors will go when funding projects.
All of this is true, if we hold the cost of starting the projects (and therefore the rate of return) constant. However, if we include the insight that “[c]ompetition between investors creates a tendency for the net present value of an investment project to equal zero” (Fuller, 2013, p. 381), then these results fail to hold. To show this, I will slightly modify Fuller’s examples.
Suppose that we have two projects that would utilize the same resources, so entrepreneurs with these two projects in mind are bidding against one another. The first project (“Project 1”) pays $1,000 of positive cash flow in each of the next three years (equivalent to Fuller’s “wooden bridge”) The second project (“Project 2”) pays $1,000 for each of 8 years, starting 3 years from now (equivalent to Fuller’s “steel bridge”). Fuller assumes that the first project will cost $2,000 to start, while the second costs $5,000. That is where the problem lies: if competitive bidding occurs, then the starting cost is not fixed. It will depend on the interest rate, and the Net Present Value (NPV) of the project with greater present value will be zero, while the less valuable project’s NPV will be negative. In short: while it is true that, “other things equal”, as the interest rate changes, the NPV will change as described by Fuller, Fuller has argued that when the interest rate changes, the startup cost of the project will change as well—and will change to keep the NPV at zero for any projects that get funded. To reexamine Fuller’s point, we calculate the Present Values (not the Net Present Values), under the assumption that the two projects are competing ways of using the same set of resources.
Table 1. Present Values
As long as the interest rate is below 28.18 percent, the longer project has a higher present value, so entrepreneurs pursuing Project 2 will get control of the resources and pursue that project. If interest rates are above 28.18 percent, then the shorter project will have a greater present value, so entrepreneurs that pursue Project 1 will win control of the resources and pursue that project.
On the whole, the story here is very similar to Fuller’s, simply because Fuller’s NPV was really just present value, but subtracting an arbitrary constant that he treated as the startup cost. However, the story changes if we allow for the startup cost to change and then look at the marginal efficiency of capital (MEC) criterion. To calculate the MEC, first I assume an interest rate. Then, I calculate the present value of the two projects. Then, I assume that the project’s startup cost is equal to the greater of the two present values. Then, I calculate the interest rate that would be required to make the Net Present Value of each project zero.
Table 2. Marginal Efficiencies of Capital
Once we correct for the changing cost of startup, the net present value and marginal efficiency criteria will give the same ordering—Project 2 is preferred if the interest rate is less than 28.18 percent, Project 1 is preferred if the interest rate is more than 28.18 percent. The reason is that the net present value of the “winning” project is zero, so the MEC of the winning project is equal to the going interest rate. The “losing” project has a negative NPV. To increase the NPV to zero, the MEC must be below the going interest rate used to calculate the original NPV.
But, what if we allow that the startup costs may be fixed? Does that suggest the rank ordering will be different for the two projects? Yes and no. Fuller has already laid out the reasons for a “yes” answer, so let me present the reasons for the “no.” If we apply the net present value criterion correctly, the decision we are making is not which of two (or more) projects to select—it is whether we should pursue a particular project at all. If the NPV is equal to or greater than zero, then investing in the project is wealth-enhancing. If the NPV is less than zero, then investing in the project is wealth-diminishing. In the following table, I assume that the startup cost is always $2,000, and bold those projects that should be undertaken. Then, I calculate the MEC for each project, assuming a $2,000 startup cost.
Table 3. Net Present Values (fixed startup cost of $2,000)
Under these assumptions, if the interest rate is less than 23.38 percent, then both Project 1 and Project 2 are undertaken according to the NPV criterion. If the interest rate is less than 26.48 percent, but greater than 23.38 percent, then Project 2 is undertaken, but Project 1 is not. If the interest rate is greater than 26.48 percent, then neither project is undertaken. By definition, the MEC of Project 1 is the interest rate that makes the NPV zero—so 23.38 percent. By definition, the MEC of Project 2 is 26.48 percent. So, using the marginal efficiencies of capital and comparing to a hurdle rate gives the same result as looking for a net present value greater than zero.
All of that said, Fuller raises an interesting point: Austrian theory is primarily about which investment projects get chosen, while Keynesian theory is driven by the question of how many projects get chosen. The goal of this comment is to add some clarification for two underlying reasons for those differences. The first reason is that Keynesian theory assumes idle resources. The second reason flows from that assumption: in Keynesian theory, prices of starting investment projects do not fully reflect expected, discounted present values of those projects—instead startup costs are “sticky.” Thus, Austrians, focusing on unsustainable malinvestments, see credit expansion as destructive while, for Keynesians, “[t]he conception of the interest rate as a hurdle rate naturally leads to a monetary policy of manipulating the interest rate.” (Fuller, 2013, p. 394)
ABSTRACT: Considerable research has been conducted on central bank monetary policies. Particular attention has been focused on policies that have the potential to ensure “sound money,” the symptoms of which are full employment and economic stability. Debate has centered on employing rule-based strategies to improve the monetary policies of the Federal Reserve Bank (“the Fed”). This article reviews the Fed’s performance with particular emphasis on its contribution to the 2008 crisis and then suggests an alternative policy which, had it been in place would have dampened the most recent boom and bust. This alternative is the application of a monetary rule that follows Wicksell’s monetary equilibrium doctrine. Although the proposed rule would not eliminate short-term price fluctuations, it should create consistent, inflation-free economic stability, a condition for sustained growth which the U.S. has not seen since the Fed’s inception.
KEYWORDS: business cycle, central banking, crisis, economic fluctuations, Fed, interest, interest rates, monetary policy, natural rate of interest, Knut WicksellJEL CLASSIFICATION: E31, E32, E42, E52, E58IntroductionIn 1945 Keynes wrote: “The monetary authorities can have any rate of interest they like. … They can make both the short and long-term [rate] whatever they like, or rather whatever they feel to be right. ...” (Rochon, 1999, p. 163). The U.S. Federal Reserve (the “Fed”) has taken full advantage of this freedom to set rates, but the results have been both disappointing and revealing.
Since the creation of the Fed, there have been eighteen recessions, of which at least four have been severe: the 1929–1933 Great Depression, the 1973–1975 recession, the 1981–1982 recession, and the 2008 recession (Amadeo, 2011). To some extent, these recessions have all been the result of inflationary policies caused by discretionary money manipulation. This assessment is neither revolutionary, nor unique. It has been the main topic of discussion throughout the history of the Fed, and the 2008 crisis again focused attention on the issue. Most recently, Selgin et al. (2012, p. 48) published an extensive study on the effectiveness of the Fed to coincide with its centennial. It concluded that significant changes in the Fed’s strategy for managing the money supply were needed.
The purpose of this paper is to respond to these authors’ call for change by postulating a monetary rule that follows Wicksell’s monetary doctrine. The goal of the rule is to match the market interest rate for loanable funds to the natural rate of interest, hereafter referred to as the “NRI” (Wicksell, 1898, p. 102). Such a strategy would induce behavior resembling that which occurs under a free and unregulated banking system. Applying this rule would keep the money supply in close proximity to the equilibrium at which supply and demand coincide. This would create an environment of inflation-free economic stability, which the Fed’s monetary policies have so far failed to produce.
Attaining this goal will be shown to be no easy task. Notwithstanding this challenge, we believe that the proposed rule should be a guide for monetary policy, since the success or failure to achieve economic stability will also be shown to depend mainly on how close the market interest rate is to its natural level, and not to the current strategy of targeting an arbitrary and desirable level of inflation.
We begin this work with a review of the Fed’s performance, paying special attention to its role in the 2008 crisis. This review demonstrates the weakness of the Fed’s monetary policies. We then demonstrate the effectiveness of the NRI rule in generating inflation-free economic stability, first using historical data on free banking and then by simulating the application of the rule in the years prior to the 2008 crisis. Finally, we suggest a mechanism whereby the Fed might implement the rule.
The Case Against the Fed's Monetary PoliciesSince its inception, the Fed has faced two significant weaknesses: susceptibility to political pressure and inadequate economic knowledge. Economists, particularly those affiliated with the Austrian School of Economics, have been pointing out these problems for close to a century, emphasizing the need to stop government interference with the market in general and its manipulation of the money supply in particular (Rosen, 2010). The latter, however, we consider only an unrealistic aspiration, at least in the foreseeable future, as there is every reason to believe that central banking will continue. The objective therefore becomes how best to minimize its unfortunate negative impact on the economy.
In articles published in 1936 and in 1945, Hayek discussed the problems generated by government interference in the market as part of his critique of socialist political systems. He explained that the knowledge necessary to run the economy is not all scientific or technical, and therefore it cannot be collected by a central entity. In fact, the necessary knowledge is dispersed among all those participating in market transactions. This ‘tacit’ knowledge is acquired by market participants in a myriad of ways, much of it spontaneously and even subconsciously. In Hayek’s opinion, the market is a process of entrepreneurial discovery, in which the entrepreneurs’ knowledge and intentions converge over time until they are perfectly coordinated, thus making it impossible for this information to be captured by a central authority. Although in his work Hayek was referring to the general market, the handling of money is merely a special case. The Hayekian knowledge problem makes it impossible for the Fed to realize its objectives on the basis of its proprietary knowledge alone. The term ‘discretionary’ is used to underline this inherent weakness of Fed policies based on in-house knowledge.
In a 1968 paper, Friedman arrived at same conclusions. Although he did not propose the abolition of the Fed, he criticized it by pointing out that the discretionary monetary policies of the Fed were erroneous in 1919–1920, in 1929–1933, in 1937–1938, in 1953–1954, and in 1959–1960.Austrian and Chicago School economists are in agreement that the Fed has erred consistently; however, they do not necessarily concur on the causes of the crisis. For example, referring to the Great Depression, Friedman et al. (2008) understood that the cause of the crisis was the “great contraction” executed between 1929–1933, however, Robbins (1934), Anderson (1949), Rothbard (1963) and Cachanosky (1989) hold that the problem originated earlier, more specifically in the credit expansion developed during the period between 1924 and 1928. In 1912, over twenty years before this crisis, Mises (1912, pp. 365–366) explained the concern as follows: "Certainly, the banks would be able to postpone the collapse; but nevertheless, as has been shown, the moment must eventually come when no further extension of the circulation of fiduciary media is possible. Then the catastrophe occurs, and its consequences are the worse and the reaction against the bull tendency of the market the stronger, the longer the period during which the rate of interest on loans has been below the natural rate of interest and the greater the extent to which roundabout processes of production that are not justified by the state of the capital market have been adopted." To this list we can now add the errors that precipitated the recessions of early 2000 and 2008. These policy failures were interrupted from the mid-1980s to the 2000s by a period frequently referred to as ‘the Great Moderation’, during which a dramatic drop in GDP volatility took place. Many economists have cited this drop in volatility as evidence that the Fed had finally learned how to manage the money supply ‘properly’. However, this claim has been refuted by statistical studies that show influences unrelated to action taken by the Fed were the reason for the unanticipated moderation (Selgin et al., 2012, p.16)
According to Friedman, the Fed did not only frequently make incorrect decisions, but also tended not to implement what would otherwise be considered desirable policies in an effective manner. In such cases it tended to act too late, and then when it finally did act, to go too far (in the ‘correct’ direction) and then finding itself in a position where a policy reversal was inevitable. According to Friedman, these overreactions have typically been the result of the Fed’s inability to time the natural delays between Fed actions and their economic consequences. Friedman’s main point, as he explained in a 1972 article, is that the expectations of the central bank are just too high. Our knowledge, he pointed out, is insufficient, and even when it is adequate, political considerations interfere with the process.
Although these issues cannot be fully eliminated, the use of rule-based monetary policies has the potential to avoid most of the undesirable consequences of discretionary central bank policies.
First, a rule has the potential to thwart political interference. Realizing this potential requires a commitment—not only from monetary policy makers, but also from politicians—to consistently apply the rule no matter what. This is certainly not a minor issue: monetary policies have traditionally been susceptible to political influence. Buchanan (1987), who made a career of researching the impact of government and politics on macroeconomics, considered political pressure on the Fed such a significant problem that he suggested its employees have their compensation fixed in nominal dollars in order to discourage them from bowing to political pressure favoring inflationary policies.
Second, reliance on a rule mitigates the knowledge problem as mechanical implementation could be accomplished without input from ‘experts’. In fact, in the 1968 article referred to above, Friedman, felt that even a computer, without any human help, could perform the task of implementing the constant money growth rule he was proposing.
Third, even if by chance the policy makers make correct assessments from the information available and are able to execute the appropriate policy, time lags will inevitably frustrate their ability to take action in a timely manner (Friedman, 1961). By the time the necessary data is collected, analyzed, and acted upon, the economy may well have moved on to another state, making the discretionary remedy inefficient or even counterproductive. This was a major factor behind Friedman’s suggestion of a constant money supply growth rule.
As an additional and significant bonus, a well-defined rule eliminates monetary uncertainties, allowing the business community to anticipate future central bank moves with accuracy and confidence, both of which are key to assuring business effectiveness (Simons, 1936).
Taylor (2011) studied the U.S. economy over the period 1950 to 2010, during which the Fed tried various monetary policy strategies. He showed that a strong correlation exists between rule-based policies and good economic performance (low inflation and unemployment levels), and just the opposite during times that the Fed used a discretionary approach to setting monetary policy.
Even ex-Chairman of the Fed, Alan Greenspan, concurs with economists who have been critical of the Fed’s discretionary policy approach. In October 2007, during a televised interview on the Daily Show, Greenspan lamented that in his 50 years as an economist he could not claim any improvement in his forecasting skills and, for that matter, he did not know anyone who could. Implicit in Greenspan’s statement is the fact that the economy is too complex to totally understand or forecast.
The 2008 crisis provides a classic example of the consequences of discretionary intervention by the Fed. The crisis originated in the United States when a major real estate bubble burst. White (2008a) demonstrated that the real estate market heated up over the period from mid-2003 to mid-2007, the four years before the crisis broke. While sales of goods and services were growing between 5 to 7 percent per annum during this period, real estate loans at commercial banks grew at levels of 10 to 17 percent or twice as fast.
The bubble began to show signs of deflating in early 2006 as prices rose to the point where purchasing a home became out of reach for most Americans, even under the very attractive terms available at the time: almost no down payment coupled with unusually low interest rates. However, as can be seen in Figure 1, the dramatic drop started in the period between late 2007 and early 2008.
Figure 1. Real Home Price Index pre-2008 Crisis
The abrupt collapse of the U.S. real estate market had a direct impact on financial markets. While in the middle of 2003 housing prices began increasing sharply, early in 2006 they took a sudden turn and declined as sharply, producing severe delinquencies and foreclosures (Taylor, 2008). This led to major financial turmoil, not only in the United States, but also around the world.
Research conducted on the 2008 crisis points to different perpetrators, from flawed financial innovations such as collateralized debt obligations (CDOs) to weak regulations, from the lack of CDO regulation to the operation of a shadow banking system, and the weakening of the existing banking system structure all compounded by government actions that allowed Fannie Mae and Freddie Mac to expand mortgages to borrowers who could not afford them by loosening down-payment standards on mortgages. But above all, the bulk of the studies reserve the blame for the Fed and its monetary policy.
In March 2001, the United States went into recession. This was the result of the technology related “dot-com bubble” that burst in the spring of 2000. This event caused the NASDAQ to fall 3,934 points, or 78 percent, between March 2000 and October 2002.The NASDAQ Composite Index reached its highest point on 10 March, 2000 at 5048.62. On 9 October, 2002 it fell to its lowest level, 1114.11 points. (Yahoo Finance, 2000–2002). To stimulate the economy, Greenspan lowered interest rates. As illustrated in Figure 2, the Fed Funds rateThe Fed Funds rate is the overnight interest rate at which banks lend funds held at the Federal Reserve to other banks and is one of the primary tools that the Fed uses to intervene in the market. had begun 2001 at 6.25 percent and ended that year at 1.75 percent, a very drastic action. The Fed did not stop there. It lowered the rate further in 2002 and 2003, and in mid-2004 it reduced the rate to a record low of 1 percent.
Figure 2. Fed Funds Rate in the 2000s
Many leading economists (e.g. Taylor [2008], Schwartz [2009], Krugman [2009], Stiglitz [2010], Ravier et al. [2012] faulted Greenspan’s discretionary monetary policy and consider it a key factor in the creation of the 2008 real estate bubble. Given this historical reality and the fact that the Fed has not been effective in applying discretionary strategies, implementation of a rigid, rule-based monetary policy deserves consideration as an alternative. The question then becomes, which rule?
The suggestion is made here that the most desirable arrangement is one in which the monetary system is as close to equilibrium as possible, i.e., the state where the behavior of the economy is not impacted by money considerations. Under these conditions, the resulting interest rate would be the natural rate of interest, as defined by Wicksell.
The Use of the NRI Rule as a Monetary PolicyThe concept of the Natural Rate of Interest (NRI) originated with the Swedish economist Knut Wicksell. In 1898, he defined the NRI as the interest rate that is commodity-price-neutral. It is set by real supply/demand factors, and not by financial markets. This can only be the case when the supply of money has no influence on the rate of interest (Wicksell, 1898, p. 102).It is worth noting that there is no complete agreement between Wicksell and Mises on the definition of the natural rate of interest. Mises (1912, p. 355) explains the differences as follows: "Wicksell distinguishes between the Natural Rate of Interest (naturliche Kapitalzins), or the rate of interest that would be determined by supply and demand if actual capital goods were lent without the mediation of money, and the Money Rate of Interest (Geldzins), or the rate of interest that is demanded and paid for loans in money or money-substitutes. The money rate of interest and the natural rate of interest need not necessarily coincide, since it is possible for the banks to extend the amount of their issues of fiduciary media as they wish and thus to exert a pressure on the money rate of interest that might bring it down to the minimum set by their costs. Nevertheless, it is certain that the money rate of interest must sooner or later come to the level of the natural rate of interest, and the problem is to say in what way this ultimate coincidence is brought about. Up to this point Wicksell commands assent; but his further argument provokes contradiction."
From this definition, one can conclude: a) that in an environment where the existing market interest rate matches the NRI, long term prices will be stable, and, b) this money-neutrality can only be expected when savings equal investments or money supply equals money demand.
If the existing market interest rate is below the NRI, it causes demand for money to be higher than the supply generated by savings. This excess demand is financed by an expansion in bank loans, which creates new money. This then pushes up the level of prices, creating inflation. The opposite occurs if the existing market interest rate is above the NRI, in which case, the money supply contracts and prices fall, creating deflation. These two scenarios are artificial and unsustainable. Thus, they cannot bring about the real, long-term economic growth that would be achievable under the NRI rule.This logic has been a predominant reason for attracting the Austrian School of Economics to monetary strategies that resemble free banking. See Cachanosky (2013) for recent work closely related to this research.
Validation of this point is to be found in historical data pre-dating central banking, in other words when there was no government interference and ‘free banking’ existed. Under such conditions, monetary equilibrium is necessarily in effect (Selgin, 1997).
Schuler (1992) and Briones et al. (2005) have identified over 70 instances of unregulated banking, mostly in the nineteenth century.On this topic, see also Dowd (1992). Of special interest is Scotland, which between 1716 and 1845 was a proven model of banking success, and is frequently employed to showcase the benefits of free banking (see for example, White [1984]).
In the United States, no true free banking existed prior to the Fed’s birth in 1913 except for the sporadic, but ineffective, attempts to move in this direction between 1836 and 1913, which took various forms in different states (Briones et al. [2005]). However, the country not only did not suffer from inflation, but for the most part, a slight deflation prevailed, symptomatic of economic growth accompanied by an absence of excess money in the system. In fact, between 1880 and 1900, real (per capita) GDP skyrocketed, going from $3,379 to $4,943 (in 2000 dollars), see White (2008b, p. 4).
This has obviously not been the situation since the inception of the Fed in 1913. As shown in Figure 3, inflation has been prevalent throughout the era of central banking and, not surprisingly, the incidences of monetary and economic instability have also increased (Selgin et al., 2012, p. 1).
Figure 3. Inflation in the U.S. (As Indicated by the Consumer Price Index)
Thus, there is little doubt that the Fed’s monetary policies have been a major cause of monetary instability. Closer examination of the 2008 crisis reveals a vivid example of misguided Fed monetary policies. During the period of time leading up to the start of the 2008 crisis, between early 2001 and mid-2004, the Fed drastically dropped interest rates, coinciding with a raise in real estate activity that reached unsustainable levels, creating a crisis that followed a typical boom and bust business cycle. Had the Fed been following the NRI rule (the free market interest rate), instead of artificially bringing the interest rate down to such extremely low levels, real estate would not have boomed so dramatically and a crisis as severe as the one that occurred in 2008 would have been avoided. To prove this statement, we estimate the NRI and then simulated the behavior of the real estate market with this rate in effect.
The literature offers a number of alternative ways of determining the NRI. From the options available we selected the methodology of Laubach and Williams (2001) because their estimate of the NRI most closely mimics Wicksell’s definition. In essence, their model attempts to find the interest rate that closes the gap between actual and potential GDP. The potential GDP, also referred to as “natural gross domestic product,” is the highest level of real GDP output that can be sustained over the long term, and which should be achieved when the prevailing interest rate and the NRI are equal.Using a statistical technique (Kalman filter), the model adjusts the estimate of the natural rate based on how far the model predicts the gap between the potential GDP and the actual GDP. If the gap is negative—meaning that the actual GDP is higher than its potential and that monetary policy is over-stimulating the economy—the natural rate is adjusted upward to bring the economy to a stable condition. Conversely, if the GDP gap is positive and the monetary policy is more restrictive than expected, the natural rate is adjusted downward.,It should also be noted that the Laubach and Williams model is widely accepted by key central banks and economists associated with the Fed, the European Central Bank, and some South American banks. See Benati and Vitale (2007) from the European Central Bank; Fuentes and Gredig (2007) from the Central Bank of Chile; Humala and Rodriguez (2011) from the Central Bank of Peru; Garnier and Wilhelmsen (2005) from the European Central Bank; Manrique and Marques (2004) from the Bank of Spain; Mésonnier and Renne (2004) from the Bank of France.
Using the Laubach and Williams approach, Figure 4 displays estimated nominal NRI and actual Federal Funds rates, during the period in question, between early 2001 and mid-2004. By simple inspection, the disparity between these two figures prior to the crisis is obvious: while the Fed funds rates dropped from 6.5 percent down to 1 percent and then increased to over 5 percent, the estimated nominal NRI fluctuated in a much more stable 4 percent to 7 percent.
Although the NRI is shown in the figure between 2000 and 2006—the entire boom and bust cycle—the only significant period of time is from the end of 2000—the beginning of the boom period—until mid-2004, when it ended, since the actions of the Fed reduced rates drastically during this portion of the cycle, and it is then that the damage was done.
Figure 4. Nominal Natural Rates versus Fed Funds Rates in the 2000s
Turning to the historical data, the major rise in real estate prices materialized soon after the fed took aggressive action to lower rates. In Figure 5, the rapid drop in the Fed Funds rate is shown to coincide with the start of the major increase in housing starts.To evaluate the real estate market, housing starts was selected, as it is perceived to be a better economic leading indicator than real estate prices. According to the Bureau of the Census of the U.S. Department of Commerce, this indicator accounts for approximately a quarter of the country’s investment spending and 5 percent of the overall economy. Sustained declines in housing starts slow the economy and can push it into a recession. The opposite, meaning an increase in housing activity, triggers economic growth and, when extreme, can turn into an unsustainable boom. Using regression analysis, a non-linear square fit correlation was used to correlate Fed Funds rates and housing starts between Jan 2000 and June 2004, the end of the boom period. The resulting quadratic equation was then used to estimate the housing starts with natural rates of interest instead of the existing Fed Funds rates. It is worth noting that the figure also shows that the Fed started to drop rates at the end of 2000, but it was not until late 2002 that the effect was fully reflected in the real estate market; on the downswing of the cycle, the real estate boom continued into the third quarter of 2005, more than a year after the Fed started to raise rates in mid-2004. Such lags typically occur between the onset of an economic problem and the full impact of a monetary policy.Economic time lags are an important issue in the development of monetary policy, and were examined in detail by Friedman in the 1961 and 1968 articles already mentioned.
Figure 5. Housing Starts versus Fed Funds Rates in the 2000s
As previously explained, the end-2000 to mid-2004 period is significant since had the real estate boom not occurred, the bust that followed would not have materialized, thereby mitigating or even eliminating all together the financial crisis that followed. Furthermore, as the simulation results presented in Figure 6 illustrate, it is highly likely that the free market generated NRI would have prevented the unsustainable real estate boom.
Figure 6. Housing Starts: Actual versus If Fed Fund Rates Equal to Natural Rates in the 2000s
Application of the Laubach and Williams proxy for the NRI in the period leading up to the 2008 sub-prime crisis and historical experience with free banking show that a monetary system constrained by free markets or an NRI rule is capable of producing price stability and sustainable economic growth. However, a return to free banking is considered unlikely, and the true NRI can only be determined in free markets. But any monetary system involving a central bank is handicapped by the knowledge problem discussed earlier, thus, it will inevitably yield an outcome that is only “second best.”
Implementation of the Proposed Rule by the Central BankAs explained earlier, the NRI is evident when monetary equilibrium is achieved ‘naturally’ in a free banking economy. Unfortunately, this figure is not observable. Consequently, for the central bank to implement the rule, it must first be estimated. This poses a problem since no reliable tools are presently available to accurately estimate NRI in real time, which is precisely when it is needed (Laubach and Williams, 2001). A different approach is thus required.
The obvious alternative to the NRI rule is a strategy that holds the nominal income/gross domestic product (NGDP) constant: this is equivalent to holding monetary equilibrium.As explained earlier, monetary equilibrium occurs when M (the quantity of money) is equal to D (the demand of money), or when M times V (the velocity of money circulation) is constant. Resorting to the equation of exchange, M times V is equal to P (price level), times Y (the real output) or NGDP. Thus, it indirectly produces the same rule and, equally important, is relatively easy to apply.
First, the NGDP is calculated by determining the money-value of all final goods and services produced in the country, a calculation routinely conducted by governments. The central bank can then select the value it wishes to hold constant—the actual number is not important. Lastly, the rule can then be enforced by adjusting the money supply to maintain the NGDP within an agreed narrow band.The Fed does not control M or V, it can only directly impact M by buying or selling securities, which increases or decreases M, respectively. The Fed can also change the discount rate, but is only a secondary tool.
Challenges to the RuleThe NGDP constant concept was proposed by Hayek (1931, p. 131) over 80 years ago in the second edition of Prices and Production as a way to prevent business cycles. However, it has never really been seriously considered because it can result in mild deflation, which mainstream economists fear may bring about economic disruptions. Their logic, as Krugman (2010) explained, is that deflation feeds on itself. Once deflation starts, prices continue to fall, because people become less willing to spend since they expect prices to fall further, making cash a very attractive, positive real-yield investment. Further, investors are also less willing to borrow even for attractive projects because they must take into account the fact that their loans will have to be repaid in dollars that have a higher purchasing power than the dollars borrowed. It is alleged that this vicious cycle of weak spending and sliding prices can be unstoppable, or at least very hard to correct.
However, the fault in this reasoning lies in not distinguishing monetarily created (bad) deflation—typically created by government interference—which in the past has generated negative consequences and so should be prevented in the future, from natural (good) deflation, which should be encouraged.
In fact, any attempt to prevent good deflation will only result in market imbalances, since eventually the adjustments must conform to the reality of supply and demand: economic disruptions are inevitable when the prices of products falling due to an increase in economic productivity are not allowed to reflect their true value.
Another problem raised by mainstream economists involves the impact of wage and price stickiness has on the economy in deflationary times. Specifically, they claim that as deflation occurs, prices—particularly retail prices—start to drop, while production costs—which are likely to be constrained by wage and price contracts—do not. Then, unmanageable business disruptions will inevitably result. However, the fact is that there is no empirical evidence that this phenomenon occurs across the entire economy. In fact, these issues occur only in particular sectors, reflecting competition within the structure of production, and do not affect the aggregate economy to the extent feared by those economists (Selgin, 1995).
Notwithstanding the laundry list of issues concerning deflation presented by mainstream economists, study after study has shown no reason to fear it. Atkeson et al. (2004) studied 17 countries, including the United States, over the period between 1880 and 2000 and found no connection between deflation and depression. In fact, they determined that the correlation between deflation and growth is stronger than with depression. The only direct link between deflation and recession occurred during the 1929–1934 Great Depression.
In another study, Friedman et al. (1971) determined that between 1880 and 1896, while the United States was under the gold standard, the country had an exceptional period of growth with a significant fall in prices. Their data showed that real income rose by about 5 percent per year while the wholesale price level fell about 1.75 percent per year.
Data from China shows that between 1998 and 2001, the country experienced growth and deflation simultaneously. On an annual basis, the real GDP went up on an average of 7.6 percent while retail prices dropped between 0.8 and 3 percent (Salerno, 2003, p. 84).
These studies are unmistakable proof that there is nothing inherently harmful in deflation, as long as it is the natural consequence of improvements, such as technological innovation, from which lower production costs are a beneficial byproduct.In a series of articles, most significantly in 1990 and 1997, Selgin introduced the “productivity norm” to support the concept of “good” deflation by pointing out that it is the natural outcome of hands-off monetary policy, or free banking. In free banking, two simultaneous monetary actions consistent with monetary equilibrium and the creation of an environment of economic growth, take place in a natural manner. NGDP stays constant as the free market equalizes money supply and demand, while the price level (P) deflates at the rate of productivity growth, meaning at the growth rate in real output (y). This is “good deflation,” like that which occurred under the gold standard period in the nineteenth century, versus the undesirable “bad deflation,” such as that which occurred during the Great Depression.
ConclusionsA wider discussion would address alternatives to eliminating the monopoly on currency and shifting to a free, fully unregulated banking system. However, our goal was narrower. Following Hayek’s argument (Hayek, 1960, p. 451) that abolition of central banking is already politically impractical and perhaps even undesirable given how we have become so accustomed to this system, we have focused our effort on finding an optimal monetary solution within an environment in which the central bank is preserved, fully aware that the outcome can be only second best.
Our proposal cannot eliminate market fluctuations that result from changes in the time preference of economic agents, technological innovations or other minor economic variables; in fact these fluctuations are healthy since they generate the price signals necessary to improve efficiency. It can, however, reduce the disruptive market cycles generated by arbitrary and politically driven credit expansions that cause short term interest rates to fall below the natural rate. The hope is that by not allowing the Fed to generate booms, the potential for economic busts can be reduced. Obviously, the degree of reduction will be determined by the ability of the Fed to follow the rule and minimize the unavoidable mistakes inherent in discretionary management of the money supply by a central bank.
Implementation of such a proposal will result in an immediate rise in interest rates to levels matching the natural rate. There is no doubt that this will bring about short term negative consequences, but once the economic system adjusts to the change, the benefits arising from monetary stability will materialize.
In this fascinating interview, Mark Thornton explains how the Austrian business cycle predicted the housing bubble, and how those cashing in on it criticized him until the bubble burst. Dr. Thornton and host Justin Mohr also discuss the US economy and how it isn't recovering, how bubble blowing from the fed might end, and the increasingly popular topic of low oil prices.
Booms and busts are not endemic to the free market, argues the Austrian theory of the business cycle, but come about through manipulation of money and credit by central banks. In this monograph, Austrian giants explain and defend the theory against alternatives. Includes essays by Mises, Rothbard, Haberler, and Hayek. In his later years, Professor Haberler distributed many of these monographs to friends and associates.
Narrated by Gennady Stolyarov II. The complete audio book (6 MP3 audio files) in a single zip file.
Download the complete audiobook (six MP3 files) here. This audiobook is also available on Apple Podcasts, Google Podcasts, and via RSS.
Economists have always been envious of the practitioners of the natural and exact sciences. They have thought that introducing the methods of natural sciences such as a laboratory where experiments could be conducted could lead to a major breakthrough in our understanding of the world of economics.
But while a laboratory is a valid way of doing things in the natural sciences, it is not so in economics. Why is that so?
A laboratory is a must in physics, for there a scientist can isolate various factors relating to the object of inquiry.
Although the scientist can isolate various factors he doesn’t, however, know the laws that govern these factors.
Hypotheses and Logical CertaintyAll that he can do is hypothesize regarding the “true law” that governs the behavior of the various particles identified.
He can never be certain regarding the “true” laws of nature. On this Murray Rothbard wrote,
The laws may only be hypothecated. Their validity can only be determined by logically deducing consequents from them, which can be verified by appeal to the laboratory facts. Even if the laws explain the facts, however, and their inferences are consistent with them, the laws of physics can never be absolutely established. For some other law may prove more elegant or capable of explaining a wider range of facts. In physics, therefore, postulated explanations have to be hypothecated in such a way that they or their consequents can be empirically tested. Even then, the laws are only tentatively rather than absolutely valid.
Contrary to the natural sciences, the factors pertaining to human action cannot be isolated and broken into their simple elements.
However, in economics we have certain knowledge about certain things, which in turn could help us to understand the world of economics.
For instance, we know that an increase in money supply results in an exchange of nothing for something. It leads to a diversion of wealth from wealth generators to non-wealth generating activities. This is certain knowledge and doesn’t need to be verified.
We also know that for a given amount of goods an increase in money supply all other things being equal must lead to more money paid for a unit of a good — an increase in the prices of goods. (Remember a price is the amount of money per unit of a good.)
We also know that if in country A, money supply grows at a faster pace than money supply in the country B, then over time, all other things being equal, the currency of A must depreciate versus the currency of B. This knowledge emanates from the law of scarcity.
Hence for something that is certain knowledge, there is no requirement for any empirical testing.
How Can This Knowledge Be Applied?For instance, if we observe a central-bank-engineered increase in the money supply — we can conclude that this resulted in a diversion of real wealth from wealth generators to non-wealth generating activities. It has resulted in the weakening of the wealth generating process.
This knowledge, however, cannot tell us about the state of the pool of real wealth and when the so-called economy is going to crumble.
Whilst we can derive certain conclusions from some factors, the complex interaction of various factors means that there is no way for us to know the importance of each factor at any given point in time.
Some factors such as money supply — because it operates with a time lag — could provide us with useful information about the future events such as boom-bust cycles and price inflation. But a change in money supply doesn’t affect all the markets instantly or equally. It goes from one individual to another individual — from one market to another market. (It is this that causes the time lag from changes in money and its effect on various markets.)
Contrary to the natural sciences, in economics — by means of the knowledge that every effect must have a cause and by understanding that (ceteris paribus) the more we have of something, the less valuable it becomes, we can logically derive the entire body of economics knowledge.
This knowledge, which should not be confused with knowledge gained from related fields such as history, economic history, and statistics, is certain and is not verified through laboratory experiments.
Image source: public domain — wikimedia — http://commons.wikimedia.org/wiki/File:Atomic_Laboratory_Experiment_on_Atomic_Materials_-_GPN-2000-000663.jpg
The present global plague of asset price inflation — with its origins in Federal Reserve quantitative easing policies and featuring much irrational exuberance — is transitioning into a new phase. Some optimistic commentators suggest a benign and painless end to the plague lies ahead. They cite the skill of the Federal Reserve in “ending QE.” These optimists even suggest that meanwhile, controlled injections of new viruses of asset price inflation by the Japanese and European central banks could have a good outcome, and this justifies the risks of the procedure. None of this optimism is justified by the evidence, nor by the known pathology of asset price inflation.
What Was Popular ThenAt the start, the plague was largely limited to commodities and emerging-economy asset markets, as the Obama Fed in 2010–11 drove the dollar downward with its launches of QE1 and QE2. The big speculative stories at the time — that investors chased — were: the Chinese mega credit-fueled boom, perpetual high growth in the emerging market economies compared to long-run stagnation in the advanced economies, and the shrinking long-run availability of key commodities, especially oil. Carry trades in the emerging market and the commodity currencies thrived.
Then, as the Draghi ECB launched its campaign to “save the euro” and Japan PM Abe embarked on his “three-arrow strategy” (QE, public spending, and reform) to bring about economic renaissance, the asset price inflation spread to Japanese equities, European equities, and once weak European “periphery” debt. Alongside, the big stories of US shale gas and Silicon Valley captivated investors. More generally, high yield corporate debt markets attracted massive inflows of funds from global yield-hungry investors.
Not Looking So Good NowNow the areas of global markets which were infected early are recording steep falls in speculative temperature. These include commodities, emerging market currencies, and commodity currencies. The US dollar has been rebounding as the Abe Bank of Japan explodes yet another QE time-bomb, and speculation is rampant that the Merkel-Draghi ECB will soon announce its own monetary experiment. One can find in previous episodes of global asset price inflation (always with its origin in the Federal Reserve) the same pattern of speculative temperatures falling in some old areas of infection even as they rise in newer areas.
For example in the great asset price inflation of the mid and late 1920s the Berlin stock market bubble burst already in 1927, the Florida real estate bubble burst in the same year, and the US real estate market peaked in the following year — all whilst the US equity market continued to inflate. A strong dollar is frequently a feature of this transitioning process as the Federal Reserve begins to reverse its policies of exceptional ease. Currency losses realized by dollar borrowers outside the US can become at such times an element in an unfolding credit crisis.
The Next Phase BeginsThe risks of credit defaults exacerbated by present or future currency falls are now looming large in Russia, Brazil, Turkey, and China. The potential crash in the Chinese currency is one of the less talked about subjects. Yet one only has to consider the massive seemingly permanent capital flight from China — financed so far by huge credit inflows into that country as the world chases high yields there — to realize how dramatic could be the turnaround.
Even so, how can we say that US monetary policy has tightened when the Fed is still pinning short-term rates down at virtually zero, 10-year Treasury yields are at 2.35 percent and the size of the Federal Reserve balance sheet (with the main liability being monetary base) is at 25percent of GDP (compared to a normal level of around 8 percent)? Well, first there has been a tightening — in relative terms — compared to actual monetary prospects in Europe and Japan. And second, the neutral level of nominal long-term interest rates has most likely been falling, meaning that the negative gap between market and neutral long-term rates has narrowed since spring 2013. (That was the Emperor’s new clothes moment, when the Fed’s power to hold 10-year rates down at around 1.5 percent was exposed as non-existent.)
In particular, inflation expectations have been falling, soothed in part by the stronger dollar and the fall in commodity prices. And the huge amount of monetary uncertainty, regarding specifically the final phase of the asset price inflation disease when speculative temperatures drop across the board and recession sets in, curbs perceived investment opportunity. Actual investment opportunity is plausibly shrinking across much of the emerging market world especially in bloated real estate and consumer credit sectors. Low long-term interest rates are a — at first glance — paradoxical symptom of the present asset price inflation and its progression toward the final deadly phase.
Where’s the Inflation?Why have inflation expectations been falling so late in the US business cycle expansion and after so many years of Fed “money printing”? The answer is partly that money printing so far has been quasi rather than the real thing. High powered money is only high powered (in terms of being the proverbial hot potato which individuals and businesses are anxious to avoid holding in excess) when the zero interest rate on monetary base contrasts with substantially positive nominal interest rates on short-maturity bills. This has not been the case in this cycle.
Goods-and-services price inflation emerges in principle when market rates are below neutral across the maturity spectrum and for an extended period of time. The Fed “achieved” this most likely in the long-maturity markets through 2010–12 but the main influence was on global asset price inflation. In goods and services markets there have been powerful real forces downward on prices resulting from profound shifts in the labor market induced by the distinct nature of present technological change.
Yes, Fed QE has weakened further the defenses of the US against the disease of goods-and-services inflation in the next cycle and beyond. The risks of manipulated rates falling below the neutral level when that eventually rises have increased substantially. But understandably for now long-term interest rate markets and business decision makers are focused on the end phase of the asset price inflation disease in the present cycle rather than what might happen next time round.
Image source: iStockphoto.
Volume 17, No. 3 (Fall 2014)ABSTRACT: The Keynesian multiplier is a concept embedded in macroeconomic thought, policy, textbooks, and widely taught in classrooms. Apparently the only controversy is its empirical size. Is the multiplier a large positive or near zero or perhaps even negative? Most empirical studies have found an impact multiplier that is positive but near zero and a long run multiplier that is larger. From an Austrian perspective, there are several problems with the multiplier concept and the research on it. Coupled with the fact that the concept fails to fully take into account opportunity costs, the multiplier concept has no basis in logic and should not be considered in policy.
KEYWORDS: Keynesian multiplier, opportunity costs, GDP gap, Austrian business cycle theory>JEL CLASSIFICATION: B40, B53, D60The recession and very slow growth of the past seven years has led to a resurgence in research on the impact of fiscal policy. The literature focuses on the Keynesian multiplier, the idea that a change in government spending will have a multiplied effect on real output or real gross domestic product (RGDP). Most of the research has been an attempt to determine the size of the multiplier. The pro-stimulus economists claim a relatively large multiplier, indicating that a government spending plan will increase RGDP far more than the incremental amount of government spending. Those opposed to this view argue that the multiplier is small, near zero, indicating that a government stimulus plan will impact RGDP, but not to the degree promoted by the Keynesian economists.
A comprehensive literature review on fiscal multipliers can be found in Baunsgaard (2012) and others who extend and update Spilimbergo, Symansky, and Schindler (2009). Studies have examined the multiplier under different economic conditions, such as Baum, et al. (2012) and Auerback and Gorodnichenko (2012b). Other studies, for example Batini, Callegari, and Melina (2012) compared multipliers in different countries. There is a remarkable disagreement among economists regarding the size of the fiscal multiplier for government spending. Barro and Redlick (2011) argued that the peacetime multiplier was essentially zero. That is, each additional dollar of government spending would displace or crowd out exactly one dollar’s worth of private consumption and investment, resulting in a negligible effect on employment. In sharp contrast, Cristina Romer (2009), as Chairman of the Council of Economic Advisors, argued that a multiplier of 1.6 should be used to estimate the new jobs that would be created by the stimulus program proposed in 2009. Ethan Ilzet, Enrique G. Medoa and Carlos A. Vegh (2011) find that the impact multiplier for high-income countries is 0.37.A selection of other studies on the multiplier is: Auerbach and Gorodnichenko (2012a, b); Batini, Callegari, and Melina (2012); Baunsgaard, Mineshima, Poplawski-Ribeiro, and Weber (2012). Christiano, Eichenbaum, and Rebelo (2011), Cimadomo (2010); Fernandez-Villaverde (2010); Gali, Lopez-Salido, and Valles (2007); Hall (2009); Monacelli and Perotti (2010); Mountford and Uhlig (2009); Ravin, Schmitt-Grohe, and Uribe (2012). They then note that since the effects take place over time, it is the cumulative or long run multiplier that is more relevant. They find the long run multiplier to be 0.80. When countries are sorted by exchange rate regime, they find countries with flexible exchanges to have a multiplier that is negative and statistically significant on impact and statistically indistinguishable from zero in the long run. In contrast, for countries with fixed exchange rates the long run multiplier is 1.5. This is just a sampling. There are many different data sets over which estimates of the multiplier have been obtained, and there is a wide range of estimated values.
Clearly the researchers attempting to determine the value of the multiplier accept the concept of a multiplier; in fact, most economists do. Only a few economists, the Austrians, question whether the multiplier makes sense. Rothbard (1962), ch. 15, “Business Fluctuations,” demonstrates that the multiplier does not come from a priori logic with his reductio ad absurdum destruction of the multiplier. Henry Hazlitt (1995 [1959]), ch. 11, “The Multiplier,” also challenged the logic of the multiplier. He said, “For while Keynes’s “multiplier” and other concepts assume unemployment, Keynes never correctly tells us the reasons for this unemployment. Those reasons always involve some disequilibrium, some maladjustment in the interrelationships of prices, wage-rates, interest rates, or other costs. No “multiplier” can be calculated or even discussed except in relation to these maladjustments. The standard criticisms of the Keynesian multiplier by the Austrians are the Hayekian central planning problem, the failure to adhere to praxeology, and the strict disregard of private property rights and the non-aggression principle. In this paper a fourth criticism is raised regarding the multiplier.
CRITICISMS OF THE KEYNESIAN MULTIPLIER CONCEPTThe first criticism is part of what Hayek calls a fatal conceit. No one can incorporate all the diffuse information that exists in the economy that is necessary to design and implement correct policies. The Austrian business cycle theory literature argues that cycles are the result of the misallocation of resources or malinvestments due to interest rates being too high or low relative to a natural rate.For a detailed discussion of the interest rate and the corresponding relationship to the business cycle, see Mises (1998 [1948]), chs. 19–20; Rothbard (1962), ch. 6; and Skousen (1990), ch. 9. It is a fatal conceit to think a particular spending program could correct the misallocation of resources. Not only does a stimulus policy exacerbate the misallocation, but it alters opportunity costs in ways that make a recovery much more difficult.
A second criticism of the Keynesian multiplier stems from Austrian criticisms of empirical studies in general. Econometric methodology presents certain variables as parameters—variables that do not change. In reality, of course they change. So the best that can be said of such analyses is that they are a study of a particular history. According to Mises,
Statistics is a method for the presentation of historical facts concerning prices and other relevant data of human action. It is not economics and cannot produce economic theorems and theories. The statistics of prices is economic history. The insight that, ceteris paribus, an increase in demand must result in an increase in prices is not derived from experience. Nobody was or ever will be in a position to observe a change in one of the market data, ceteris paribus. There is no such thing as quantitative economics. All economic quantities we know about are data of economic history. (Mises, 1998, pp. 247–248)
The empirical studies are based on economic history, where no ceteris paribus exists.
The third criticism of the multiplier concept is the disregard of private property rights. Government spending requires that resources be taken from the private sector. If the spending is financed with taxes, then those funds are unusable by the private sector. If the spending is financed with borrowing, then the private sector investment is crowded out by the government sector currently, and in the future, taxes have to be used to pay for the borrowing. If the borrowing is financed by money expansion, then the increased money supply leads to interest rates that differ from the natural rate and lead to malinvestment. In all cases, coercion is used to obtain the financing for government spending. Private property rights are not respected, the values of assets are altered. Property is taken from some and given to others, and the owners are not fully compensated. The government spending comes at the expense of private spending, and government borrowing comes at the expense of private borrowing.
Another problem with the concept of a multiplier stems from a failure to recognize the full opportunity cost of the idle resources. The typical measure of the opportunity costs of idle resources is the GDP gap. It is presented as
GDP gap = potential – actual real gross domestic product.
Potential real gross domestic product (RGDP) is the RGDP that would have been produced had the economy been operating on the boundary of the production possibilities curve, that is, the RGDP that would have been created if resources had been fully and efficiently used. It is then argued by pro-government-spending advocates that government spending would put idle resources back to work and move the economy back toward or even to the potential RGDP level, depending on how much crowding out occurs. This leaves out a crucial aspect of the economy. The RGDP gap is not a measure of opportunity costs because it is not possible to say that the potential RGDP is an efficient allocation or that the level of use at potential GDP is full use. Potential GDP is the estimated GDP that could be obtained with the current resource allocation. Nothing suggests that the current allocation measured by RGDP would move to the efficient allocation if aggregate demand were increased. What does occur is that the current misallocation of resources is exacerbated.
Suppose the economy has been distorted by a policy that has driven the rate of interest below the natural rate. Then we could define two potential GDP levels. One is a potential GDP level where resources are allocated according to relative resource prices prior to the government caused misallocation. We will call this the Austrian GDP (AGDP). This differs from the typical potential GDP, which is merely an exacerbation of misallocated resources. Then, AGDP minus potential GDP is the opportunity cost of misallocated resources. No amount of government spending could move GDP to AGDP even if it could move GDP to potential GDP.
When an intervention in the free market occurs, investments do not flow to where resources would have the highest value. Instead, they are moved into less valuable activities, those favored by the intervention. The only way for the malinvestment to be corrected is for individual resource prices to adjust and resources to again flow to their highest valued uses.
In a free market, one of the effects of resources being idle is that downward pressure is put on their relative prices to adjust. For instance, if employers observe a quantity of idle resources that could augment or replace those the employer is currently using, then a lower wage or rent or interest could be offered the resources. Higher profits, more jobs, and greater production would result. If resources are not idle but are being used in way that is inefficient, then the downward pressure on resource prices would not be the same as if the resources were idle. Thus, the opportunity cost of having resources idle is not just the lost output of having them idle, but must include the cost of misallocated but not idle resources, that is the inability to reach AGDP. This misallocation lengthens the term of misallocation and underproduction. Once the government intervention has exacerbated the resource misallocation, an adjustment to AGDP would be much more costly than if the intervention and initial misallocation had not taken place?
Attempting to stimulate the economy via a government spending and monetary expansion program only makes the misallocation much worse. For instance, hiring unemployed to dig holes and then to fill the holes, has no effect on the creation of goods and services but does reduce the downward pressure on certain resource prices.“If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.” Keynes (2007 [1936]). Such a stimulus program would lengthen the time the economy takes to move back toward efficient allocation. Rather than a 1920–21 downturn and quick recovery, we experience a 2008–2014/15 type of downturn and stagnation.
Resources are allocated to the many varied industries and firms in an economy and at any given time some firms or industries may have an incorrect amount of a resource given current prices. If the government chooses to increase spending in order to reduce general unemployment it will further misallocate resources. In some industries or firms, the increased spending could drive up wages without increasing employment. In others there might be some employment increase. Overall, however, the aggregate spending increase does not match the distribution of resources throughout the economy.
Hayek made similar points about the Keynesian multiplier, but some of his arguments have not gotten widespread recognition they deserved.Hayek (2009 [1974]), pp. 27–37, 59–67. He argued that the Keynesian multiplier analysis starts with the implicit assumption that no factors of production are scarce, that is, that the supplies of all inputs are infinitely elastic below the level of full employment.
…the effect of making this assumption will be that we must distinguish between the effects which an increase of investments and income will have while there are unused resources of all kinds available and the effects which such an increase will have after the various resources become successively scarce and their prices begin to rise. (Hayek, 2009 [1974], p. 28)
The assumption means there are no opportunity costs to government expenditures. But, the assumption is contrary to reality. Resources are always scarce; there are always opportunity costs.
Salerno (2009, p. xvii) clearly summarizes Hayek’s argument.
In Keynes’s illusory world of superabundance, an increase in total money expenditure will indeed increase employment and real income, because all the resources needed for any production process will be available in the correct proportions at current prices. However, in the real world of scarcity, as Hayek shows, unemployed resources will be of specific kinds and in specific industries, for example unionized labor in mining or steel fabrication. Under these circumstances, an increase in expenditure will increase employment, but only by raising overall prices and making it temporarily profitable to re-employ these idle resources by combining them with resources misdirected away from other industries where they were already employed. When costs of production have once again caught up with the rise in output prices, unemployment will once again appear, but this time in a more severe form because of the misallocation of additional resources.
It is impossible to know how the current resource allocation relates to potential RGDP. As Hoppe (1995, II) said:
The non praxeologists also believe that relationships between certain events are well established empirical laws (with predictive implications) when a priori reasoning can show them to be no more than information regarding contingent historical connections between events, which does not provide us with any knowledge whatsoever regarding the future course of events.
A priori reasoning indicates that the full opportunity cost must include the cost of malinvestment and the exacerbation of that misallocation resulting from an attempt to close the GDP gap. And this cost, the difference between AGDP and potential GDP, is impossible to measure.
Consider an economy in which manipulation of the interest rate has led to malinvestments and a resulting financial crash. A stimulus package consisting of an increase in government spending financed by debt is undertaken. According to Keynesian theory, this leads to an increase in aggregate demand followed by a multiplied increase in output. But, the economy prior to the implementation of the stimulus package was not allocating resources to where they had the highest value. The malinvestment caused by manipulation of the interest rate led to the misallocation of resources. The demand for labor in specific industries or firms does not match the distribution of aggregate demand.
As Hayek noted, any increase in employment resulting from a stimulus policy is short-term and is dependent on a continual acceleration of inflation. The unemployment that exists after the breakdown of an inflationary boom is not “general” in the Keynesian sense, but instead is confined to specific firms and industries and is caused by the mismatching of the demand for labor and the pre-recession distribution of the labor supply among the various firms and industries. Increasing aggregate demand will only freeze the non-optimal pattern of relative prices and employment prevailing during the inflationary boom immediately prior to the recession.Hayek (2009 [1974]), pp. 59–67 So the increased government spending exacerbates the misallocation rather than ameliorates it. Output is not actually increased because the wrong goods are produced with the wrong resources at the wrong costs. Measuring the impact of the stimulus on output does not take into account the misallocation of resources. So even if some type of “multiplier” is found empirically, it has no meaning.
Another way of looking at the issue is through the Austrian business cycle theory. In the Austrian view, economic output is disaggregated by stages of production and time. First stage expenditures were committed to the production of second stage capital goods two periods ago and expenditures on second stage capital goods were committed to final goods last period. Without government intervention, this disaggregation, unlike in mainstream macroeconomics, means that wages do not all fall when GDP declines. Though falling profits decrease labor demand and wages in the final stage, labor demand and wages in earlier stages rise as firms redirect resources. The widening wage differential draws workers to earlier production stages. This flow of labor resources reduces final stage labor supply and raises earlier stage labor supply, resulting in the final stage wage rising up toward the wage that prevailed in earlier expanding stages. After investments have worked their way through the economy, the productive capacity of the economy has expanded, resulting in higher overall consumption.
However, this adjustment process does not work when government interferes in markets. For instance, when the central bank creates reserves, interest rates fall, investment increases, and savings decline. The investment is misallocated and results in a competition for resources, which pushes asset prices higher. The impact of the government and/or monetary expansion is not multiplied in terms of real output. It instead leads to increased misallocation of resources and a collapse of the unsustainable demand. There is no Keynesian multiplier effect.
CONCLUSIONSEconomic research indicates that most economists buy into the concept of the Keynesian multiplier. Some argue that its value is positive while others say it is near zero. But no matter what value is found, the multiplier concept itself makes no sense. It cannot be supported on a priori logical grounds. To argue for a Keynesian multiplier is to ignore Hayek’s fatal conceit, ignore the logic of praxeology, ignore the fact that empirically found relationships are at best historical artifacts, and to ignore the opportunity cost of misallocated resources.
In a recent paper cited last month in The Economist, a trio of economists ran a kitchen sink’s worth of correlations on investment numbers. Kothari et al. concluded that profit growth and stock price boost investment, but that interest rates have a negative effect. This claim runs counter to Austrian business cycle theory, so let’s have a look.
Despite their data actually saying that lower rates actually lower investment, Kothari, et al. conclude there is “little evidence” of a relationship. I guess they have to say this because, otherwise, people would laugh. Why would people laugh? Because if your data says that lower prices lead to lower demand, you either have bad data, or you have too much noise.
Either way it’s not causal, and it could be embarrassing to say it is. Am I being unfair to Kothari? Does not data speak the phoenix of truth, arising from the ashes of superstition? Well, when the data says something that contradicts elementary theory, you have three choices as a researcher. First, maybe the theory is wrong. Second, you check whether your data is wrong: too many zeros? Is it mistyped? (Notorious economist Thomas Piketty might have benefited from this.) Third, you conclude the data is noisy. Therefore it is not saying what you think it’s saying.
Well, the theory that a lower price for an identical product raises demand is pretty sound — that’s why demand curves slope downward. If it were not true, I would buy Cokes for a dollar, sell them for ten, and have a line around the block.
So if the theory is sound, then the remaining possibilities are that it’s bad data — either it’s a typo or it’s full of noise. I have no reason to doubt Kothari et al.’s figures, and MIT runs a tight ship. So it’s probably not typos.
So we zero in on that noise. Can we think of any noisy factors surrounding interest rate policy? Wait, perhaps you’ve heard of something called a central bank.
It’s a fairly uncontroversial assertion that central banks don’t raise or lower interest rates randomly, like fluctuations in temperature. It’s not a “random walk,” with Bernanke and Yellen flipping coins over lunch. Rather, central bankers move interest rates at specific moments: they raise them when they think the economy might “overheat,” and they lower when they think it is at risk of recession.
This means that central banks raise rates specifically when they expect investment to be strong (“overheat”). And they lower rates specifically when they expect investment to fall (“recession”).
So what Kothari et al. are missing is that investment trends actually cause rate changes. Central bankers’ expectations of overheating cause higher rates, and their expectations of recessions cause lower rates. So we would indeed expect that falling expected investment would be associated with lower rates, but the causation here isn’t rates-to-investment, its investment-to-rates, with a stopover in the vivid imagination of some central bankers.
So we’ve got two causal relations. First, from Econ101, that lower prices raise demand of identical products: “low rates raise investment.” Then we can toss in the causal relationship where high investment scares the Fed into raising rates: “raised investment raises rates.” And now we’ve got two correct causal chains that exactly contradict. We’ve spotted our noise. And now we have the likely explanation.
As a nice bonus, we also now have the truly helpful interpretation we should take away Kothari et al.’s findings: that the central bank’s reactive rate movements fail to smooth the boom-bust cycles they set in motion. Of course, we all know this, since we live in the real world and observe business cycles in the wild, despite our imaginative and apparently busy central bankers.
Kothari et al. can be seen as a contribution for its confirmation of a key Austrian claim, that central banks can’t tame the storms they raise. But the paper certainly does not mean what its authors think it means — that interest rates are relatively innocent bystanders in the business cycle.
Image source: iStockphoto.
The Economist recently opined that interest rates don't affect investment. This claim is based on an empirical study that contradicts what we already know: that lower prices lead to more demand. In the end, the problem lies with the researches who fail to account for the behavior of central bankers, writes Peter St. Onge.
This audio Mises Daily is narrated by Robert Hale.
Tom Woods offers a simple explanation of Austrian Business Cycle Theory. Excerpted from his 2009 lecture entitled "Why You've Never Heard of the Great Depression of 1920".
There are strong indications that the remarkable run up of asset prices in the last few years is beginning to run out of steam and may be on the verge of collapse. We will leave aside the question of whether the asset inflation is symptomatic of a garden-variety inflationary boom or is a more virulent bubble phenomenon in which prices are rising today simply because buyers anticipate that they will rise tomorrow.
The Evidence
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The dizzying climb of London real estate prices since the financial crisis, noted in a recent post by Dave Howden, may be fizzling out. Survey data from real-estate agents indicate London housing prices in September fell 0.1 percent from August, their first decline since November 2012. Meanwhile, an index of U.K. housing prices declined for the first time in 17 months. In explaining the "pronounced slowdown" in the London real estate market, the research director of Hometrack Ltd. commented, “Buyer uncertainty is growing in the face of a possible interest-rate rise, a general election on the horizon and recent warnings of a house-price bubble,” which is playing out "against a backdrop of tougher mortgage affordability checks and limits on high loan-to-income lending."
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Just released data from the Dow Jones S&P/Case Schiller Composite Home Price Indices through July 2014 shows a marked deceleration of U.S. housing prices. 17 of the 20 cities included in the 20-City Composite Index experienced lower price increases in July than in the previous month. Both the 10- and 20-City Index recorded a 6.7 percent year-over-year rate of increase, down sharply from the post-crisis peak of almost 14 percent less than a year ago.
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More ominously, U.S. Total Household Net Worth (HNW), as recently reported by the Fed for the second quarter of 2014, reached a record high of $81.5 trillion, over $10 trillion higher than the level at the peak of the asset bubble in 2007. Furthermore, the 2014 figure was $20 trillion higher than the level of the post-crisis — and pre-QE — year of 2008, when asset prices and the real structure of production were just beginning to adjust to the massive capital consumption and malinvestment wreaked by the Great Asset Inflation of 1995-2005. The increase in household wealth has been driven mainly by the increase in prices of financial assets which was generated by the Fed's zero interest rate policy and its force feeding of additional bank reserves into the financial system via its quantitative easing programs. (See chart below). These policies falsify profit and wealth calculations and give rise to unsustainable investments and overconsumption. Once interest rates begin to adjust to their natural levels, however, asset prices are revealed to be grossly inflated and collapse. The asset inflation may be reversed even without an increase of interest rates, if people lose confidence in the narratives fabricated and propagated by government policymakers, economists, and the financial commentators to promote the continuation of the inflation in asset markets. Furthermore it is risible to believe that real wealth in the US in terms of the factories and other capital goods to which financial assets are merely ownership claims, has increased by over one-third since 2008, especially in light of the additional malinvestment and overconsumption caused by monetary and fiscal policy “stimulus” since then.
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If we look at HNW in historical perspective, we note that, in the chart below, the HNW/GDP (or wealth to income) ratio is now at an all-time high. From 1952 to the mid-1990s this ratio averaged a little more than 350 percent and never went above 400 percent until 1998 as the dot-com bubble was blowing up. It peaked at nearly 450 percent before the bubble collapsed causing the ratio to plummet to slightly below 400 percent, indicating the beginning of the purging of the illusory capital gains created during the asset inflation.
But just as the adjustment was beginning to take hold in 2002, the Greenspan Fed played the deflationphobia card, driving interest rates to postwar lows and pumping up the money supply (MZM) by $2 trillion from beginning of 2001 to the end of2005. During this second phase of the Great Asset Inflation, the HNW/GDP ratio again reached a new high before plunging below 400 percent during the financial crisis. And, tragically, the nascent readjustment of financial markets to the underlying reality of the economy’s shattered and shrunken production structure was yet again aborted by government intervention in the form of the heterodox monetary policies of Bernankeism combined with the outsized deficits of the Obama administration. These policies succeeded in driving the HNW/GDP ratio to yet another new high, but without having the expected stimulatory effect on consumption and investment spending.
Conclusion
In sum, I do not expect that the ratio will rise much above 500 percent — Americans have just not saved enough since 1995 to have increased their real wealth from 3.5 times to 5 times their annual income. Nor is there much reason to expect a plateau anywhere near the current level. Once interest rates begin to rise — and rise they must, whether as a result of Fed policy or not — the end of the asset price inflation will be at hand. The result will be another financial crisis and accompanying recession. The Fed and the Administration will no doubt attempt to bail and stimulate their way out but given the still dangerously enervated state of the financial system and the real economy, it will be like dosing a horse that has already been overdosed to death. Thus my forecast for the U.S. economy one year to two years out echoes that of Clubber Lang, the villain in the movie Rocky III. When questioned about his forecast for the forthcoming fight against Rocky, Lang replied, “Pain.”
Image source: iStockphoto.
[From The Essential von Mises]
Included in The Theory of Money and Credit were at least the rudiments of another magnificent accomplishment of Ludwig von Mises: the long-sought explanation for that mysterious and troubling economic phenomenon—the business cycle. Ever since the development of industry and the advanced market economy in the late eighteenth century, observers had noted that the market economy is subject to a seemingly endless series of alternating booms and busts, expansions, sometimes escalating into runaway inflation or severe panics and depressions. Economists had attempted many explanations, but even the best of them suffered from one fundamental flaw: none of them attempted to integrate the explanation of the business cycle with the general analysis of the economic system, with the “micro” theory of prices and production. In fact, it was difficult to do so, because general economic analysis shows the market economy to be tending toward “equilibrium,” with full employment, minimal errors of forecasting, etc. Whence, then, the continuing series of booms or busts?
Ludwig von Mises saw that, since the market economy could not itself lead to a continuing round of booms and busts, the explanation must then lie outside the market: in some external intervention. He built his great business cycle theory on three previously unconnected elements.
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One was the Ricardian demonstration of the way in which government and the banking system habitually expand money and credit, driving prices up (the boom) and causing an outflow of gold and a subsequent contraction of money and prices (the bust). Mises realized that this was an excellent preliminary model, but that it did not explain how the production system was deeply affected by the boom or why a depression should then be made inevitable.
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Another element was the Böhm-Bawerk analysis of capital and the structure of production.
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A third was the Swedish “Austrian” Knut Wicksell’s demonstration of the importance to the productive system and the prices of a gap between the “natural” rate of interest (the rate of interest without the interference of bank credit expansion) and the rate as actually affected by bank loans.
From these three important but scattered theories, Mises constructed his great theory of the business cycle. Into the smoothly functioning and harmonious market economy comes the expansion of bank credit and bank money, encouraged and promoted by the government and its central bank. As the banks expand the supply of money (notes or deposits) and lend the new money to business, they push the rate of interest below the “natural” or time preference rate, i.e., the free-market rate which reflects the voluntary proportions of consumption and investment by the public. As the interest rate is artificially lowered, the businesses take the new money and expand the structure of production, adding to capital investment, especially in the “remote” processes of production: in lengthy projects, machinery, industrial raw materials, and so on. The new money is used to bid up wages and other costs and to transfer resources into these earlier or “higher” orders of investment. Then, when the workers and other producers receive the new money, their time preferences having remained unchanged, they spend it in the old proportions. But this means that the public will not be saving enough to purchase the new high-order investments, and a collapse of those businesses and investments becomes inevitable. The recession or depression is then seen as an inevitable re-adjustment of the production system, by which the market liquidates the unsound “over-investments” of the inflationary boom and returns to the consumption/investment proportion preferred by the consumers.
Mises thus for the first time integrated the explanation of the business cycle with general “micro-economic” analysis. The inflationary expansion of money by the governmentally run banking system creates over-investment in the capital goods industries and under-investment in consumer goods, and the “recession” or “depression” is the necessary process by which the market liquidates the distortions of the boom and returns to the free-market system of production organized to serve the consumers. Recovery arrives when this adjustment process is completed.
The policy conclusions implied by the Misesian theory are the diametric opposite of the current fashion, whether “Keynesian” or “post-Keynesian.” If the government and its banking system are inflating credit, the Misesian prescription is (a) to stop inflating posthaste, and (b) not to interfere with the recession-adjustment, not prop up wage rates, prices, consumption or unsound investments, so as to allow the necessary liquidating process to do its work as quickly and smoothly as possible. The prescription is precisely the same if the economy is already in a recession.
In "The Theory of Money and Credit", Mises provided the basics for the long-sought explanation for that mysterious and troubling economic phenomenon — the business cycle, writes Murray Rothbard. This audio Mises Daily is narrated by Robert Hale.
Robert Blumen, a software engineer with a background in financial applications, recently spoke with the Mises Institute about the Austrian School’s growing influence among investors.
Mises Institute: In recent years, we’ve seen more and more Austrian-tinged economic analysis coming from investors like Mark Spitznagel and Jim Rogers, to just name two. As someone personally involved in the investment world, have you yourself seen growth in Austrian ideas among investors and similar professionals?
Robert Blumen: There has been tremendous growth in interest in Austrian economics among financial professionals. I started an interest group for Austrians in Finance on LinkedIn which, in a few years, has grown to almost 2,000 members from the US, South America, East, Southern, and Central Asia, Africa, and Eastern and Western Europe. Peter Schiff appears regularly on financial shows. The Mises Institute drew hundreds of people from the investment world to an event in Manhattan.
Since 2002, a number of Austrian-themed books in financial economics have come out. Alongside titles from established writers such as James Grant, there is Detlev Schlichter’s Paper Money Collapse, and several books by Peter Schiff. There are many popular Austrian bloggers such as Grant Smith and Robert Wenzel. Over two million viewers watched a 2006 video in which a parade of condescending media hosts heap ridicule on Peter Schiff, who, to his credit, did not back down in the face of their smugness.
MI: Did the financial crisis of 2008 help increase the sympathy for Austrian economics?
RB: I have heard the same story from many people in finance. When the bust of 2000 (or 2008) happened, it did not fit what they had been taught in school, nor could it be explained within the belief systems of their colleagues in financial markets. Their next step was reading, searching for answers, and then, finding the writings of Mises, Hayek, or Rothbard that enabled them to make sense of what had happened.
To answer your question, yes, I think that the failure of the popular economic theories — evidenced by these inexplicable crises — has driven the search for superior ideas. The Mises Institute has been publishing for years, explaining these boom and bust cycles with Austrian economics. When people searched, many of them ended up at mises.org.
MI: In spite of lackluster growth on Main Street, Wall Street appears quite happy with growth over the past two years. For the casual observer, one might argue that the Fed has managed things well. What do you see as problematic with the current approach, and are there some in the finance world skeptical of the Fed’s current strategy?
RB: The Fed has a series of mistaken theories supporting their belief that higher stock prices indicate the success of their policies.
The first is the thinking that asset prices are actual wealth, when they are only the prices of the capital goods, which are a form of real wealth. Asset prices, in real terms, are the exchange ratios between consumption goods and capital goods. Artificially-boosted asset prices mean only that the owners of assets who bought them at lower prices have increased their consumption possibilities in relation to non-owners of assets. The owners of most assets, the so-called “1 percent” are the beneficiaries of Fed policies.
There is no systemic economic benefit to any particular value for stock prices. Young people saving for the future and entrepreneurs who are looking to pick up capital goods at bargain prices would find lower stock prices give them a better deal. This is the same as for any good.
Their second error is that higher stock prices create a “wealth effect,” in which people see their asset values rise, feel richer, and consequently save less and spend more. Their goal is to boost consumption through pumping up asset prices. As Keynesians, they are all in favor of this because they think that consumption drives production.
Sound economic thought has recognized, at least since the classical school, that production must precede consumption, and that production drives demand, not the other way around. The Fed understands none of this because they have no understanding of the purpose of capital goods in the production process, which is to increase the productivity of labor.
They believe this about home prices as well, which is arguably an even greater fallacy because homes are consumption goods. A rising standard of living means that we are able to buy consumption goods at lower real prices over time, not higher.
And finally, they see the stock market as a sort of public referendum on their policies. They point to the stock market and say, “see, the market approves of what we are doing.” But when you realize that through its monetary expansion, the Fed itself is responsible for the rising stock market, that calls into question whether we can use it as independent measure of public opinion, or instead, the Fed voting for itself with money that it prints.
Austrian-informed financial thinkers understand this. There are hundreds of Austrian-oriented blogs and commentary sites, as well as some excellent heterodox sites with a very Austrian-friendly perspective such as Zero Hedge, Jim Rickards, Marc Faber, and Fofoa.
MI: We’ve mostly been talking about the US so far, but speaking globally, do you see any areas that are of particular concern, such as China or the Euro zone?
RB: Credit allocation in China is not market-based. They import the Fed’s inflation through their currency peg, which diverts dollars into their sovereign wealth fund where it is “invested” by bureaucrats in various forms of dollar-zone assets. Their domestic savings go into their banking system, where it is wasted on politically-favored projects due to non-market allocation of bank credit. The entire system is experiencing a series of bubbles in real estate and other sectors.
Their rate of infrastructure spending for comparably developed economies is about twice as high as normal. This is because the communist party officials are under great pressure to hit GDP targets — as if prosperity could be spent into existence by hitting a number. Infrastructure such as roads and empty cities present an opportunity to spend a large amount of money, all in one place, on a lot of Very Big Stuff, which under market-based economic calculation would be revealed as wasteful.
The problems in Europe are a combination of the massive debts that can never be paid back, the unfunded entitlements, and the growth in the burden on producers, a theme that I addressed in my recent Mises Daily article on Say’s law. This burden consists of the totality of regulation, taxation, inflexible prices and labor markets, and the threat to the confiscation of wealth. If you project these trends into the near future, I’m not sure where the lines cross, but the system is clearly unsustainable in its present form because it relies on sustaining current levels of consumption as fewer and fewer people produce.
Image source: iStockphoto
Jeff Deist and David Howden discuss the history of banking in America before 1913, the supposed justifications for the Federal Reserve Act, and why American economists all seem to be thrall to—and on the payroll of—the Fed. David also lays out the realities behind transitioning to a future without the Fed. Next, they discuss his book about the Icelandic banking crisis, and how that country's deposit insurance scheme created enormous moral hazards. David explains how Iceland, however, mostly had the good sense to allow its bad banks to fail and its foreign creditors to take a well-deserved haircut. The lessons to be learned, he tells us, are both cautionary and optimistic, at least for a homogeneous nation of 325,000 people.
We live at a time when politicians and bureaucrats only know one public policy: more and bigger government. Yet, there was a time when even those who served in government defended limited and smaller government. One of the greatest of these died one hundred years ago on August 27, 1914, the Austrian economist Eugen von Böhm-Bawerk.
Böhm-Bawerk is most famous as one of the leading critics of Marxism and socialism in the years before the First World War. He is equally famous as one of the developers of “marginal utility” theory as the basis of showing the logic and workings of the competitive market price system.
But he also served three times as the finance minister of the old Austro-Hungarian Empire, during which he staunchly fought for lower government spending and taxing, balanced budgets, and a sound monetary system based on the gold standard.
Danger of Out-of-Control Government Spending Even after Böhm-Bawerk had left public office he continued to warn of the dangers of uncontrolled government spending and borrowing as the road to ruin in his native Austria-Hungary, and in words that ring as true today as when he wrote them a century ago.
In January 1914, just a little more than a half a year before the start of the First World War, Böhm-Bawerk said in a series of articles in one of the most prominent Vienna newspapers that the Austrian government was following a policy of fiscal irresponsibility. During the preceding three years, government expenditures had increased by 60 percent, and for each of these years the government’s deficit had equaled approximately 15 percent of total spending.
The reason, Böhm-Bawerk said, was that the Austrian parliament and government were enveloped in a spider’s web of special-interest politics. Made up of a large number of different linguistic and national groups, the Austro-Hungarian Empire was being corrupted through abuse of the democratic process, with each interest group using the political system to gain privileges and favors at the expense of others.
Böhm-Bawerk explained:
We have seen innumerable variations of the vexing game of trying to generate political contentment through material concessions. If formerly the Parliaments were the guardians of thrift, they are today far more like its sworn enemies.
Nowadays the political and nationalist parties … are in the habit of cultivating a greed of all kinds of benefits for their co-nationals or constituencies that they regard as a veritable duty, and should the political situation be correspondingly favorable, that is to say correspondingly unfavorable for the Government, then political pressure will produce what is wanted. Often enough, though, because of the carefully calculated rivalry and jealousy between parties, what has been granted to one [group] has also to be conceded to others—from a single costly concession springs a whole bundle of costly concessions.
He accused the Austrian government of having “squandered amidst our good fortune [of economic prosperity] everything, but everything, down to the last penny, that could be grabbed by tightening the tax-screw and anticipating future sources of income to the upper limit” by borrowing in the present at the expense of the future.
For some time, he said, “a very large number of our public authorities have been living beyond their means.” Such a fiscal policy, Böhm-Bawerk feared, was threatening the long-run financial stability and soundness of the entire country.
Eight months later, in August 1914, Austria-Hungary and the rest of Europe stumbled into the cataclysm that became World War I. And far more than merely the finances of the Austro-Hungarian Empire were in ruins when that war ended four years later, since the Empire itself disappeared from the map of Europe.
A Man of Honesty and Integrity Eugen von Böhm-Bawerk was born on February 12, 1851 in Brno, capital of the Austrian province of Moravia (now the eastern portion of the Czech Republic). He died on August 27, 1914, at the age of 63, just as the First World War was beginning.
Ten years after Böhm-Bawerk’s death, one of his students, the Austrian economist Ludwig von Mises, wrote a memorial essay about his teacher. Mises said:
Eugen von Böhm-Bawerk will remain unforgettable to all who have known him. The students who were fortunate enough to be members of his seminar [at the University of Vienna] will never lose what they have gained from the contact with this great mind. To the politicians who have come into contact with the statesman, his extreme honesty, selflessness and dedication to duty will forever remain a shining example.
And no citizen of this country [Austria] should ever forget the last Austrian minister offinance who, in spite of all obstacles, was seriously trying to maintain order of the public finances and to prevent the approaching financial catastrophe. Even when all those who have been personally close to Böhm-Bawerk will have left this life, his scientific work will continue to live and bear fruit.
Another of Böhm-Bawerk’s students, Joseph A. Schumpeter, spoke in the same glowing terms of his teacher, saying, “he was not only one of the most brilliant figures in the scientific life of his time, but also an example of that rarest of statesmen, a great minister of finance…. As a public servant, he stood up to the most difficult and thankless task of politics, the task of defending sound financial principles.”
The scientific contributions to which both Mises and Schumpeter referred were Böhm-Bawerk’s writings on what has become known as the Austrian theory of capital and interest, and his equally insightful formulation of the Austrian theory of value and price.
The Austrian Theory of Subjective Value The Austrian school of economics began 1871 with the publication of Carl Menger’s Principles of Economics. In this work, Menger challenged the fundamental premises of the classical economists, from Adam Smith through David Ricardo to John Stuart Mill. Menger argued that the labor theory of value was flawed in presuming that the value of goods was determined by the relative quantities of labor that had been expended in their manufacture.
Instead, Menger formulated a subjective theory of value, reasoning that value originates in the mind of an evaluator. The value of means reflects the value of the ends they might enable the evaluator to obtain. Labor, therefore, like raw materials and other resources, derives value from the value of the goods it can produce. From this starting point Menger outlined a theory of the value of goods and factors of production, and a theory of the limits of exchange and the formation of prices.
Böhm-Bawerk and his future brother-in-law and also later-to-be-famous contributor to the Austrian school, Friedrich von Wieser, came across Menger’s book shortly after its publication. Both immediately saw the significance of the new subjective approach for the development of economic theory.
In the mid-1870s, Böhm-Bawerk entered the Austrian civil service, soon rising in rank in the Ministry of Finance working on reforming the Austrian tax system. But in 1880, with Menger’s assistance, Böhm-Bawerk was appointed a professor at the University of Innsbruck, a position he held until 1889.
Böhm-Bawerk’s Writings on Value and Price During this period he wrote the two books that were to establish his reputation as one of the leading economists of his time, Capital and Interest, vol. I, History and Critique of Interest Theories (1884), and vol. II, Positive Theory of Capital (1889). A third volume, Further Essays on Capital and Interest, appeared in 1914 shortly before his death.
In the first volume of Capital and Interest, Böhm-Bawerk presented a wide and detailed critical study of theories of the origin of and basis for interest from the ancient world to his own time. But it was in the second work, in which he offered a Positive Theory of Capital, that Böhm-Bawerk’s major contribution to the body of Austrian economics may be found. In the middle of the volume is a 135-page digression in which he presents a refined statement of the Austrian subjective theory of value and price. He develops in meticulous detail the theory of marginal utility, showing the logic of how individuals come to evaluate and weigh alternatives among which they may choose and the process that leads to decisions to select certain preferred combinations guided by the marginal principle. And he shows how the same concept of marginal utility explains the origin and significance of cost and the assigned valuations to the factors of production.
In the section on price formation, Böhm-Bawerk develops a theory of how the subjective valuations of buyers and sellers create incentives for the parties on both sides of the market to initiate pricing bids and offers. He explains how the logic of price creation by the market participants also determines the range in which any market-clearing, or equilibrium, price must finally settle, given the maximum demand prices and the minimum supply prices, respectively, of the competing buyers and sellers.
Capital and Time Investment as the Sources of Prosperity It is impossible to do full justice to Böhm-Bawerk’s theory of capital and interest. But in the barest of outlines, he argued that for man to attain his various desired ends he must discover the causal processes through which labor and resources at his disposal may be used for his purposes. Central to this discovery process is the insight that often the most effective path to a desired goal is through “roundabout” methods of production. A man will be able to catch more fish in a shorter amount of time if he first devotes the time to constructing a fishing net out of vines, hollowing out a tree trunk as a canoe, and carving a tree branch into a paddle.
Greater productivity will often be forthcoming in the future if the individual is willing to undertake, therefore, a certain “period of production,” during which resources and labor are set to work to manufacture the capital—the fishing net, canoe, and paddle—that is then employed to paddle out into the lagoon where larger and more fish may be available.
But the time involved to undertake and implement these more roundabout methods of production involve a cost. The individual must be willing to forgo (often less productive) production activities in the more immediate future (wading into the lagoon using a tree branch as a spear) because that labor and those resources are tied up in a more time-consuming method of production, the more productive results from which will only be forthcoming later.
Interest on a Loan Reflects the Value of Time This led Böhm-Bawerk to his theory of interest. Obviously, individuals evaluating the production possibilities just discussed must weigh ends available sooner versus other (perhaps more productive) ends that might be obtainable later. As a rule, Böhm-Bawerk argued, individuals prefer goods sooner rather than later.
Each individual places a premium on goods available in the present and discounts to some degree goods that can only be achieved further in the future. Since individuals have different premiums and discounts (time-preferences), there are potential mutual gains from trade. That is the source of the rate of interest: it is the price of trading consumption and production goods across time.
Böhm-Bawerk Refutes Marx’s Critique of Capitalism One of Böhm-Bawerk’s most important applications of his theory was the refutation of the Marxian exploitation theory that employers make profits by depriving workers of the full value of what their labor produces. He presented his critique of Marx’s theory in the first volume of Capital and Interest and in a long essay originally published in 1896 on the “Unresolved Contradictions in the Marxian Economic System.” In essence, Böhm-Bawerk argued that Marx had confused interest with profit. In the long run no profits can continue to be earned in a competitive market because entrepreneurs will bid up the prices of factors of production and compete down the prices of consumer goods.
But all production takes time. If that period is of any significant length, the workers must be able to sustain themselves until the product is ready for sale. If they are unwilling or unable to sustain themselves, someone else must advance the money (wages) to enable them to consume in the meantime.
This, Böhm-Bawerk explained, is what the capitalist does. He saves, forgoing consumption or other uses of his wealth, and those savings are the source of the workers’ wages during the production process. What Marx called the capitalists’ “exploitative profits” Böhm-Bawerk showed to be the implicit interest payment for advancing money to workers during the time-consuming, roundabout processes of production.
Defending Fiscal Restraint in the Austrian Finance Ministry In 1889, Böhm-Bawerk was called back from the academic world to the Austrian Ministry of Finance, where he worked on reforming the systems of direct and indirect taxation. He was promoted to head of the tax department in 1891. A year later he was vice president of the national commission that proposed putting Austria-Hungary on a gold standard as a means of establishing a sound monetary system free from direct government manipulation of the monetary printing press.
Three times he served as minister of finance, briefly in 1895, again in 1896–1897, and then from 1900 to 1904. During the last four-year term Böhm-Bawerk demonstrated his commitment to fiscal conservatism, with government spending and taxing kept strictly under control.
However, Ernest von Koerber, the Austrian prime minister in whose government Böhm-Bawerk served, devised a grandiose and vastly expensive public works scheme in the name of economic development. An extensive network of railway lines and canals were to be constructed to connect various parts of the Austro-Hungarian Empire—subsidizing in the process a wide variety of special-interest groups in what today would be described as a “stimulus” program for supposed “jobs-creation.”
Böhm-Bawerk tirelessly fought against what he considered fiscal extravagance that would require higher taxes and greater debt when there was no persuasive evidence that the industrial benefits would justify the expense. At Council of Ministers meetings Böhm-Bawerk even boldly argued against spending proposals presented by the Austrian Emperor, Franz Josef, who presided over the sessions.
When finally he resigned from the Ministry of Finance in October 1904, Böhm-Bawerk had succeeded in preventing most of Prime Minister Koerber’s giant spending project. But he chose to step down because of what he considered to be corrupt financial “irregularities” in the defense budget of the Austrian military.
However, Böhm-Bawerk’s 1914 articles on government finance indicate that the wave of government spending he had battled so hard against broke through once he was no longer there to fight it.
Political Control or Economic Law A few months after his passing, in December 1914, his last essay appeared in print, a lengthy piece on “Control or Economic Law?” He explained that various interest groups in society, most especially trade unions, suffer from a false conception that through their use or the threat of force, they are able to raise wages permanently above the market’s estimate of the value of various types of labor.
Arbitrarily setting wages and prices higher than what employers and buyers think labor and goods are worth—such as with a government-mandated minimum wage law—merely prices some labor and goods out of the market.
Furthermore, when unions impose high nonmarket wages on the employers in an industry, the unions succeed only in temporarily eating into the employers’ profit margins and creating the incentive for those employers to leave that sector of the economy and take with them those workers’ jobs.
What makes the real wages of workers rise in the long run, Böhm-Bawerk argued, was capital formation and investment in those more roundabout methods of production that increase the productivity of workers and therefore make their labor services more valuable in the long run, while also increasing the quantity of goods and services they can buy with their market wages.
To his last, Eugen von Böhm-Bawerk defended reason and the logic of the market against the emotional appeals and faulty reasoning of those who wished to use power and the government to acquire from others what they could not obtain through free competition. His contributions to economic theory and economic policy show him as one of the greatest economists of all time, as well as his example as a principled man of uncompromising integrity who in the political arena unswervingly fought for the free market and limited government.
Originally published September 6, 2014.
Volume 1, No. 4 (Winter 1998)One of Ludwig von Mises’s most important contributions to economic science was the business cycle theory that he first presented in his Theory of Money and Credit (1981, ch. 19, esp. pp. 338ff.). This theory has been elaborated by Mises himself and received important additions through the hands of Friedrich A. Hayek and Murray N. Rothbard.[1] Yet in its foundations it remains unshaken as from the day of its first publication.The purpose of this article is threefold. First, we challenge Mises’s theory by arguing that it is not generally and apodictically valid. Therefore, it cannot be part of economic theory which, as Mises himself stated, is a purely logical science of action. Second, we give the outlines of a truly praxeological (and therefore general) theory of error cycles that withstands this specific criticism. And third, Mises’s business cycle theory will be restated in the light of the new approach, that is, it will be interpreted as an instance of a more general theory and thus put on more solid grounds.
A Critique of Austrian Business Cycle TheoryError and Business CyclesAny business cycle theory is essentially a theory of error. Its aim is to explain the recurrence of the phenomenon that we call crisis; that is, a situation in which the simultaneous economic failure of many people becomes obvious. Thus, business cycle theory not only has to explain the occurrence of error but the recurrence of a cluster of errors as well. This reminder is especially useful since many economists tend to interpret the business cycle as an equilibrium phenomenon.[2] Let us spell out what that means in terms ordinary people use. It means that these writers contend that bankruptcies are planned, that the loss of big and small fortunes was intended from the outset, and that people could conceive of no better employment for their labor and money than throwing it out the window.It is to the great merit of the Austrian business cycle theory that it explains recurrent errors in investment decisions by a common cause, namely, the monetary organization that prevails in western civilization. The main features of this system are fractional reserve banks and a central bank operating as a lender of last resort. Under these circumstances commercial banks can unexpectedly increase the quantity of money substitutes (today mainly demand deposits) and, by lending this new money out, push the market interest rates below the level they would have otherwise reached. Thus, with the given production capacities more investment projects are begun than can ultimately be sustained. A systematic error has occurred. It is impossible that all projects are successfully carried out, and this must sooner or later be discovered. When this discovery gains widespread attention, the business cycle has reached the crisis phase. The supposedly least profitable projects are now abandoned and production continues on a more solid base. However, the source that brought about the systematic error is still operating. Still, commercial banks can increase the quantity of their money holdings beyond the quantity of money they may dispose of. And still the central bank helps them in cases of “liquidity crises.” Therefore, systematic error is likely to occur again.Error or failure is a permanent condition of human endeavor. It consists of choosing an alternative for action that is less important (less preferred) than another one that could have been executed instead. Austrian business cycle theory does not have to assume that, were it not for inflation, the market participants would not err at all. It can rely entirely on the idea that inflation causes additional errors; that is, more errors than otherwise would have occurred: “Credit expansion in the midst of unemployment will create more distortions and malinvestments, delay recovery from the preceding boom, and make a more grueling recovery necessary in the future” (Rothbard 1983, p. 34).[3] Thus, the Austrian approach gives a realistic account of the trade cycle and provides the only solution that exists to the theoretical problems raised by any business cycle theory.[4]
General Refutation of the Consequential Analysis of ErrorHowever, even the present Austrian solution is defective because it relies on a fallacious analysis of error. Ultimately, the traditional Austrian approach consists of giving an explanation of how error comes about. It is what could be called a consequentialist explanation. Error is conceived as the consequence of a preceding event; namely, of a change in the conditions of action.[5] Thus, Austrian business cycle theory explains clusters of errors by changes in the quantity of money. It claims that market participants err because the quantity of money is increased by the banking system. Their error is manifest in an interest rate that is too low in respect to the prevailing social time-preference.Before we come to a refutation of this theory, we should note a crucial but hitherto neglected fact. That is, the problem raised by the analysis of error exceeds the limits of business cycle theory. It is a fairly general problem, and it calls for a general solution. For whatever the explanation of error might be, it would have to hold not only for error clusters but also for individual errors. The theory that changes cause error is a general solution, even if we can demonstrate it to be wrong. And if we venture to propose a better theory it must necessarily be a general solution as well. In other terms, business cycle theory must be grounded in a general theory of the recurrence of clusters of errors.According to the consequentialist approach, error is impossible and equilibrium must prevail if conditions do not change any more. Error can only occur if conditions change. However, the crucial problem is that obviously not all changes necessarily lead to error. For example, the fact that, for the payment of wages, one needs more cash at the beginning of a month does not surprise the businessman. Or, even if more legs were broken in 1999 than in 1998 this would probably not cause the bankruptcy of health insurance companies. How can these undeniable facts be reconciled with the consequentialist approach? One could claim these changes are part of a larger class of events which, as a class, do not vary in the course of time. Dealing with single elements of a class implies a certain risk, but it does not lead to error. Only if the behavior of the entire class varied would error ensue. Error could thus be conceived of as the consequence of singular changes of class behavior. Similarly, other singular events like the discovery of a law of nature or the invention of an unheard-of product bring about error, too. It is this error-inducing singularity that, according to consequentialism, constitutes what is called uncertainty.[6] However, the existence of singular events could only serve as a basis for a consequentialist explanation of error, if they implied error. Otherwise, a mere change of conditions, and even a singular one, could never be a sufficient explanation of error. Does the occurrence of singular events necessarily lead to error? This is the decisive question. Only if this was the case could there ever be a consequentialist business cycle theory. Yet it is definitely not the case. Error cannot be explained by singular changes of conditions because even such changes can be anticipated. Anticipation does not, of course, mean that one knows what will happen in the future. This could never be the case. Rather it means that one judges correctly what the future conditions will be (Hülsmann 1997). We may admit that the conditions of action change every instant, but this does not prevent us from anticipating them.Another way of attacking consequentialism would be to claim that there can be no singular events in human history. However, this criticism would be unjustified. He who denies the existence of singularity would have to claim that all possible events could be classified in advance. He would also have to make this claim for future states of knowledge. Yet such a claim would be self-contradictory because once people know this general classification they will behave differently, upsetting the pattern that, before, explained their actions (Hoppe 1983; 1997). Thus, human choice and creativity account for the singular events that defy all-encompassing classifications.Rejecting the consequentialist approach to the explanation of error, we side with common sense. For, if error was the necessary consequence of some preceding event then we would have to deny the notion of choice altogether. Freedom of choice does not, to be sure, mean that one can choose any end that one would like to attain. It is not the realm of our fancies. In each choice we can choose the most important among the available alternatives, and we can choose a just action rather than committing a crime. We always have the power to do this. The claim that a previous event determines the success of our action corresponds exactly to the dubious statement that one had to murder one’s grandmother because one was born poor.
Refutation of the Consequentialist Approach to Business Cycle TheoryHow does the preceding discussion translate into the realm of business cycle theory? The consequentialist approach implied in the traditional Austrian theory states that clusters of errors on the market are the consequence of increases in the quantity of money. Yet, such increases can be anticipated. The mere fact that the quantity of money changes does not prevent the entrepreneurs from judging correctly what influence it will exercise on market prices. Therefore, an increased quantity of money does not imply that too low of an interest rate be established. This point has been conceded by Mises:
It may be that business men will in the future react to credit expansion in another manner than they did in the past. It may be that they will avoid using for an expansion of their operations the easy money available, because they will keep in mind the inevitable end of the boom. (Mises 1940, pp. 696f.)[7]
One critical remark needs to be added to this statement. It concerns the question of precisely how the correct interest rate would be established in spite of an ongoing inflation. Mises claims that a more prudent attitude toward the “easy money available” would avoid the business cycle. Such an attitude among the owners of the most profitable businesses would merely drive the interest rate down and thus strengthen their competitors. Rather, the correct interest rate would be established by credit-taking entrepreneurs, who anticipate that the increased quantity of money will permit higher selling prices in the future. These entrepreneurs would bid for higher interest rates; that is, they would create a higher price premium on the gross market rate of interest. From this it follows that inflation is never favorable to the prudent. It changes the conditions of economic success in favor of the gamblers and rent-seekers (Hülsmann 1996b, pp. 197ff.).In Mises’s view, a business cycle is unavoidable whenever the entrepreneurs do not refrain from using additional fiduciary media. He said: “Issuance of fiduciary media, no matter what its quantity may be, always sets in motion those changes in the price structure the description of which is the task of the trade cycle” (Mises 1998, p. 442, n. 17). Therefore, all that could be done was to restrict credit as soon as the symptoms of the business cycle appear. Then “the boom comes to an early end; a recession starts” (ibid., p. 798). In this context, Mises explicitly denies the validity of the above argument that error could be avoided by entrepreneurs establishing a higher price premium on interest rates in advance of the future effects of inflation. He claims that the “price premium always lags behind the changes in purchasing power because what generates it is not the change in the supply of money (in the broader sense), but the—necessarily later-occurring—effects of these changes upon the price structure” (ibid., p. 545).[8] Thus, Mises holds that the causation at work necessarily proceeds in two steps. At first, the inflation creates higher prices for the factors of production while interest rates remain unaffected or are even lowered (which is what constitutes the error). Then this price increase is incorporated into expectations and brings about a higher price premium on interest rates.[9]However, this reasoning is defective on several grounds. First of all, Mises gives no argument why the actors could not “compute in advance the date and the extent of [the price changes generated by the alteration in the money relation] with regard to all commodities and services which directly or indirectly count for their own state of satisfaction” (Mises 1998, p. 544). He merely contends that “such computations cannot be established because their performance would require a perfect knowledge of future conditions and valuations” (ibid.). Of course, we do not have to quarrel about whether human beings enjoy perfect foresight or not. This is not the question at stake. The question is not whether people are likely never to fail but whether it is conceivable that they do not err in their undertakings. The answer to this latter question is unambiguous: people definitely can anticipate future events. This is a serious problem for Mises’s business cycle theory, which relies on the proposition that inflation implies error. Indeed, the concept of implication in its strong praxeological sense permits no conceivable exceptions. If it is possible that the effects of inflation are correctly anticipated then inflation does not necessarily lead to error. A theory stressing an inflation-induced error cycle then must fall to the ground. But let us concede Mises’s point for the sake of argument. Let us admit that it is impossible that all market participants anticipate the effects of inflation on all commodities. The question remains, then, whether this is really required for a price premium to be established in advance of future events. And this question has to be answered in the negative. As we have stated above, business cycle theory does not have to rely on the assumption that there was no error at all before the cause of the business cycle set in.[10] It is sufficient to explain why more errors then occur. Similarly, for a price premium to be established in advance, it is not necessary to stipulate that all market participants anticipate the effects of inflation. We merely assume that anticipating the effects of inflation is not more difficult than anticipating the effects of other changes. If this is the case, then, there will be no cluster of errors in consequence of inflation; that is, there will be no business cycle.Before dealing with the important issue of whether or not reckoning with inflation is more difficult than anticipating other changes, let us briefly discuss two other problems in Mises’s argument. The first refers to his account of the price premium in the final state of a ceaseless inflation. Here, Mises claims, “things become different. The panic of the currency catastrophe, the crack-up boom, is not only characterized by a tendency for prices to rise beyond all measure, but also by a rise beyond all measure of the positive price premium” (1998, p. 545). Now, this clearly contradicts his claim that price premiums always lag behind the changes in purchasing power. For if they did they would have to do so in hyperinflations, as well. Mises could, therefore, give no explanation of the enormous price premiums in hyperinflation. If, by contrast, price premiums did not always lag behind changes in purchasing power then error would not necessarily follow from inflation. Mises’s trade cycle theory would thus again be contradicted. A further problem concerns a contradiction between his consequentialist approach to business cycle theory and his more general explanation of profits and losses. Mises’s central tenet in the latter is that the
only source from which an entrepreneur’s profits stem is his ability to anticipate better than other people the future demand of the consumers. . . the real entrepreneur is a speculator, a man eager to utilize his opinion about the future structure of the market for business operations promising profits. This specific anticipative understanding of the conditions of the uncertain future defies any rules and systematization. (Mises 1998, pp. 290, 585)[11]
In other words, it is not a specific event that causes error and thereby profits and losses. Rather, it is entrepreneurial ability alone; that is, entrepreneurial choice that manifests errors on the one hand and correct expectations on the other hand.Mises neither explains why inflation always leads to error nor why the market participants cannot anticipate its effects. He therefore fails to prove that inflation implies error. It would also not be a sufficient solution to claim that credit expansions “distort” prices and calculations. This would require an explanation of the difference between distortions and normal modifications of the price structure. Indeed, all ongoing events exert some influence on prices and calculations. All of them could therefore be said to distort prices. Murray Rothbard has attempted to solve this problem in the following way:
Bank credit expansion distorts the market’s reflection of the pattern of voluntary time preferences; the gold inflow embodies changes in the structure of voluntary time preferences . . . time preferences may temporarily fall during the transition period before the effect of increased gold on the price system is completed . . . The fall will cause a temporary increase in saved funds, an increase that will disappear once the effects of the new money on prices are completed. (Rothbard 1983, p. 38)
Of course, time preferences may fall during the transition period as well as rise. The question, however, is not what may happen to time preferences but whether they have to fall (or rise) as a consequence of increased gold. Is a lower time preference implied in an increase of money? This would be irreconcilable with the theory of value to which Rothbard adheres. Consumers’ preferences are not already implied in some quantities of commodities. Therefore, time preference, which is but the temporal aspect of consumer’s choices, cannot be determined by the quantity of gold. But, even if we admit Rothbard’s point for the sake of argument, it would be impossible to arrive at his conclusion. For why, one would have to ask, does this point apply only to gold? Why does an increase of fiat money not lead to falling time preferences as well? Here, Rothbard fails to establish a viable distinction. He merely asserts that bank credit distorts whereas a gold inflow embodies real changes.Now, let us come back to the question of whether reckoning with inflation is more difficult than, say, reckoning with a change in consumer demand from one product to another or in the savings-consumption schedules. This argument has also been advanced by Rothbard. He states:
[entrepreneurs] could not forecast the results of a credit expansion, because the credit expansion tampered with all their moorings, and distorted interest rates and calculations of capital. No such tampering takes place when gold flows into the economy, and the normal forecasting ability of the entrepreneurs is allowed full sway. (Rothbard 1983, p. 38)[12]
Strictly speaking, Rothbard’s statement reduces to the claim that it is more difficult to forecast credit expansions because it is more difficult to forecast them. He uses different words to distinguish the influence of credit expansions from those of other changes like changes in consumer demand, when he says that credit expansions “distort” prices and calculation. As we have seen above, this chain of reasoning begs the question. However, a somewhat different argument seems to be implied in the expression “tampering” insofar as this is meant to suggest an influence that is hidden from the rest of the market participants. According to this argument, it would not be increases in the quantity of money as such that lead to error. Rather, clusters of error would result only if these increases were veiled. Moreover, and most importantly, Rothbard suggests that tampering is more likely to occur under government interventions than on the free market. Thus, the emphasis of the argument is shifted to completely different grounds. Clusters of errors are no longer explained in the narrow terms of monetary changes but in the wider ones of government activities. This new emphasis will indeed play an important role in the present article.To complete our critique of the traditional Austrian business cycle theory, let us restate our main tenet, namely, that taking account of inflation is not a problem distinct from other problems of anticipation. The effects of inflation can be anticipated. Therefore, inflation does not imply error. The significance of this conclusion for economic theory can hardly be overemphasized. For, it means that the inflation-induced business cycle is, at least in light of the traditional theory, not a matter of logical necessity but of historical contingency. Whereas this fact has been clearly recognized (Lachmann 1943, pp. 108ff.; Selgin 1990, p. 53n; Salerno 1995 pp. 307ff.) it seems as if its full importance for business cycle theory has been ignored. If error is not necessarily related to inflation, then there is no Austrian account of the recurrence of error. If an increase in the quantity of money can cause widespread error today and no error at all tomorrow, then clusters of business errors can hardly be deduced from inflation alone. Rather one would now have to explain under which conditions inflation leads to error and under which conditions it does not. This additional explanation would then be the business cycle theory. As long as this explanation does not exist—and it does not exist—we cannot avoid the conclusion that, at present, there is no Austrian business cycle theory at all.In a certain sense, we are back to zero. If change as such cannot be the cause of error, then a business cycle theory seems to be impossible. This, however, is but a manifestation of the fundamental defect of all consequentialist approaches to the explanation of error. All attempts to conceive of error as the consequence of some preceding event must fail. As long as human beings choose, that is, as long as they are beings with free will, the correctness of choice must in principle be unrelated to preceding events and choices. Instances of error cannot lend themselves to a consequentialist explanation.What are, then, the theoretical options that we face—apart from abandoning the idea of a business cycle theory altogether?[13] In what follows we shall argue that there is not only a case for Austrian business cycle theory, but that it can be derived from the framework of a general theory of error cycles. However, in contrast to the traditional consequentialist approach we shall explain the recurrence of clusters of errors along essentialist lines.
An Essentialist Approach to the Analysis of Error CyclesThe Error CycleThe essentialist approach to the analysis of error does not attempt to deduce error from preceding events. Rather, it takes error as an ultimate given, submitting it to a purely logical investigation. It completely abandons the question, How does error come about?, in favor of the question, What are the implications of error?The theory of error cycles starts from the fact that error is committed at the moment of choice but only revealed in the future (Menger 1976, pp. 67–71). There is always a time lag between a wrong choice and the discovery that it was a wrong choice, and at the moment of choice, one is never aware of one’s errors—otherwise one would not engage in this action at all. The necessary time lag between an error and its discovery implies an error cycle, with all the familiar features of the business cycle theory. Fundamentally, two stages can be distinguished. At the beginning of the first stage the error is committed. During this error phase, acting man believes he attains more important ends than he actually is able to attain (in business cycle theory this phase is somewhat misleadingly called “boom”). The longer the error stage, the more investment decisions will be made on the grounds of the erroneous assumption.[14] The “crisis” marks the point of time when the error is discovered. Then begins the second stage, a phase of reestablished sobriety. In the crisis, acting man discovers the extent of the damage done in the past. He gains a sober insight into the real options that he now faces. His actions are put again on a sound basis—until the next error occurs.Thus, the general theory of error cycles departs from an analysis of individual errors. Any crisis can be described in terms of an individual error cycle. However, our aim is not to explain the particular errors that invariably occur as long as there is human life. We have to explain the recurrence of clusters of errors, that is, the repetitive occurrence of more or less synchronous errors of many persons by deducing them from a common cause. Therefore, a program for the essentialist explanation of recurrent clusters of errors has to identify more or less permanent patterns of action (institutions) in which the error of many persons is inherent. Instances of crises are then explained as situations in which many acting persons become aware of their errors or of the consequences of their errors.
The Use of Government as an IllusionThere are many institutions involving many people. In light of the consequentialist approach to the explanation of error, all lend themselves to the explanation of clusters of errors. The only problem left would be to explain the recurrence of those clusters. However, if we think along essentialist lines, then the main problem is to find institutions in which some kind of error is inherent. This is a serious problem because institutions should be expected to serve the endeavors of acting man rather than to obstruct them. And even if one can conceive of erroneous institutions, it seems to be somewhat difficult to prove that they are inherently erroneous. It is, for example, a common phenomenon that an institution becomes superfluous when conditions change. But this implies that it has served at least for a while beforehand. Rather than being inherently erroneous it simply failed as the conditions of action changed.[15] By contrast, how is it conceivable that an institution is erroneous irrespective of all other conditions of action? We must look for a kind of error that is independent of time and place. Only an institution built upon such an error is an inherently erroneous institution. Such an error, which is independent of time and place, we call illusion.Now, there is a kind of widespread institution in which illusion is inherent. This institution is government; that is, a person or a group of persons who permanently violate property rights of other people (the subjects of government).[16] To what extent does the existence of government represent a general illusion on the side of its subjects? Let us, first, observe that each society is based on a private-property régime as its nucleus of civilization. There can be no society where there is no peaceful appropriation based on self-ownership. For we can only meaningfully speak of society if one has the right to appropriate yet unowned goods, to transform them through the expense of one’s labor, and to exchange them against other goods on the market. Any appropriation inconsistent with these three ways would mean that the appropriator claims a right that he denies to his fellow; that is, ultimately, the right to self-ownership. As far as such aggressive acts occur there is no society but civil war, be it open or suppressed. Non-aggressive actions are a necessary feature of human life and of civilization. Violations of property represent partial obstructions of life in society. This does not mean that, in reality, there are no aggressive acts. There will be aggression as long as there are remnants of the human race. However, the crucial point is that aggressive actions do not constitute a society; they rather destroy its achievements. Thus, they represent additional problems for those eager to profit from the division of labor. They are additional problems because any act of violence presupposes that the goods that are violently appropriated or modified have been rightfully possessed beforehand. A purely private-property régime is logically prior to violent interventions.[17] Hence, the problems created by the latter must be added to the problems confronting any civilization.The illusion in the context of aggression is only implied in the deliberate institution of violence; that is, in government. It does not refer to aggression as such. The victim of ordinary “private” violence is very conscious of what is going on. But most victims of governmental violence believe that this aggression is necessary for life in society. No one has expressed this more brilliantly and concisely than Bastiat (1986, p. 252), who defined government as “the great fiction by the help of which everybody tries to live at the expenses of all other people.”[18] This fiction or illusion is precisely what distinguishes governments from ordinary aggressors. The existence of a government presupposes that a majority of the population (or, in any case, many persons) support it. Each government needs the consent of the majority in order to establish its rule.[19] This, in turn, presupposes that these people believe aggression to be useful in respect to purposes different from those of mere exploitation. People believe that aggression is necessary to produce certain goods like protection, insurance, education, judicial advice, etc. This, however, is a blatant error. Any good can be produced on the market if consumers are willing to give enough of their property in exchange for it. If a good cannot be produced profitably, this means that the market participants do conceive of more important uses of their property. Employing aggression to produce the good does not change this fact. It merely takes away the factors of production from enterprises which would have used them in a way that, according to the valuations of property owners, is more important.Before we enter into further discussion, note that all the formal conditions for a general theory of recurrent clusters of errors are fulfilled in this new approach: because government is an institution, it can account for the recurrence of error in the course of time. Because it is an institution involving many people, it can account for clusters of error. Furthermore, there can be no government without an illusion (that government is a part of, and necessary for, life in society) being widespread. Therefore, government and recurrent clusters of error always go hand-in-hand. They coexist. No consequentialist argument is needed to establish this connection.
Government and Error CyclesLike any other institutionalized large activity, government has a profound impact on society. It shapes society’s capital and knowledge structure, and its structure of character types. For example, consider the case of government subsidies for aircraft production. They keep the subsidized enterprises in business longer than they would be otherwise. Capital is replaced in aircraft production rather than being invested elsewhere. Certain quantities of steel, electricity, land, workers, etc. are bound up in the production of airplanes rather than, say, in the production of trains or the printing of books. As a consequence, people continue to learn all of the things needed for aircraft production rather than learning about how to make better trains or books. Some people now even begin to learn things needed for the acquisition of government funds. They learn how to lobby, how to bribe, how to recognize the best moment for asking for more funds, how to smear and threaten any opposition. These are the effects not only of subsidies but of any government intervention. Without it, these sorts of capital goods and knowledge and character would be valueless. In today’s industrialized nations there are many industries and professions that depend entirely on the existence of government. Just think of the farmers, Europe’s steel and coal industries, operas and orchestras, teachers and professors at public schools and universities, and of course public utilities and other government agencies like the IRS, the Supreme Court, the Department of Justice, etc. What would all these organizations and persons do without government intervention on their behalf? They would not survive for a minute. The organizations would go bankrupt and the persons would have to start from scratch, rebuilding their human capital. Yet why should a government ever cease all or part of its interventions, thus inducing a crisis? This is the question our essentialist error cycle theory has to answer.One general answer is, because government interventions do harm some people to the profit of other people, and because some of these persons do not fall prey to the illusion that government is necessary or beneficial. They will try to enlighten their fellows about the true nature of government. Whenever they succeed in doing so government is doomed and with it the human capital and other capital that depends on it. This is the illusion cycle of government in its most general form. Let us observe that we do not have to make any assumptions about when the attempts to abolish government succeed. We merely have to state that a government can be abolished and that, if it is abolished, the illusion is brought to an end. However, our main interest is not in single illusion cycles but in explaining recurrent general crises. Thus, the decisive question is whether government intervention as such, or at least some kind of government intervention, must necessarily lead to breakdowns that make the general error evident without yet being necessarily accompanied by an abolition of government. In this case, a future repetition of the intervention would be possible and lead to further breakdowns and cycles. This would be an explanation for the recurrence of general crises.Thus, let us first analyze a kind of government intervention that accounts for recurrent crises. Government activity must lead to recurrent general breakdowns whenever it implies fraud. The victim of fraudulent behavior is not aware of his situation and thus behaves as if everything was still in order. He thinks that he still can realize all the projects he had planned. He does not know that the quantity of his means has been diminished. Therefore, he will not adjust the structure of his property to the new circumstances. He is likely to leave for holidays in cases where he should rather begin to save and live from hand to mouth. If fraud occurs on a large scale, society’s capital structure will be distorted in an exactly analogous way. People do not apprehend that the capital stock has been diminished by the embezzler and needs to be refilled through savings. Sooner or later they will discover this error. This is when the crisis sets in. Now, it is true that fraud could occur even if no government existed. Even a free society could be partially obstructed by more or less large-scale fraud. However, the crucial fact is that these partial obstructions of the market could never account for the recurrence of crises. In a free society, no embezzler could continue his business and quietly prepare the next fraud. This is a privilege of governments, insofar as they operate under the general illusion that they are necessary for the working of society. In many cases governments can commit fraud without that fraud being recognized as such (this is especially the case with money, which we will discuss in the next section). Even if government’s fraud is recognized as being fraud this does not lead to government’s abolition as long as the general public is deluded about its nature. The king might abdicate or the members of parliament might change, but not the institution of government itself. Thus, fraud will be tried again and subsequently provoke the next crisis. In this account we do not have to stipulate that all of government’s attempts to commit fraud succeed (whereas, for example, the consequentialist approach to business cycle theory has to stipulate a necessary relationship between increases of the quantity of money and error). We merely have to point out that a government can commit fraud and that, if it commits fraud, this does not lead to its abolition.Now let us deal with the question of whether all kinds of government intervention must, in the long run, lead to breakdown. We think the answer is in the affirmative, and it is based on Mises’s famous calculation argument. The more intervention increases the less it can work, because it impedes economic calculation. The more private property is violated the more the price system, and thus the basis for a rational allocation of resources, is distorted.[20] Increased intervention brings about reduced efficiency in capital investments. Small interventions might not render calculation impossible, but interventions might not remain small because of competition on the political level and because there is no natural limit for government growth outside the exploitable stock of property.[21] One thing is sure—individuals and groups competing for government power will never be satisfied with the present level of interventionism. Warmongers long for bigger armies, statist teachers want to keep the children longer in school, some political entrepreneurs ask for export guaranties, others want to prevent unfair competition on the domestic market, etc. The only question is whether they get their way. Because government rests entirely on an illusion, its further growth requires the present level of illusion to be extended. In order to grow, government must, by whatever device, make its subjects believe that they profit from its new actions. Here it enjoys two big advantages. On the one hand, the subjects already believe government to be necessary, if only within certain limits. Therefore, new encroachments of government do not differ in principle but only in degree from its earlier activities. The existence of government implies that some aggression is held to be necessary. As the distinction between peaceful action and aggression is permanently blurred, the promotion of more far-reaching illusions is facilitated. On the other hand, the negative impact of interventionism on prosperity can only be established by sound reasoning and never just by reference to observations. If people begin to starve, the statists claim that this is not because of, but in spite of, interventionism. Rather than being reduced, government needs more power to bring the cure.The outcome of the ideological struggle for and against government is an empirical question.[22] Either the statists and the friends of liberty might prevail when Armageddon comes. But this indeterminacy poses no problem for our theory. All that counts for our purposes is that the statists can win the struggle. In this case there will be a general economic downturn because no developed structure of capital can be maintained or extended without the possibility of economic calculation. Government will consume more and more property until nothing is left that still could be consumed. Total confidence in government leads to total government; that is, to all-encompassing socialism and to all-encompassing capital consumption. The end-state of really-existing socialism, for example, bore all the characteristics of a long illusion cycle.
At the moment when a country is forced to abandon communism, it does not find itself on the level that was reached at the beginning of the communist phase but at a very much lower one, virtually nowhere. This is so not only with regard to the economy, but equally with regard to the political institutions, to social relationships, to cultural life. (Revel 1992, pp. 219f.)
If, then, government is not abandoned, the next cycle will be already on the way.
General and Specific Cycle TheoriesWe have outlined a general theory that allows us to deduce recurrent clusters of error from the very existence of government. It might be useful to add an observation on the application of our theory to more concrete cases. Government activity and widespread errors necessarily go in hand. This is the central tenet of our theory. However, the fact that the existence of government is a manifestation of error is entirely independent of the question of where government is manifested in concreto. The general theory of error cycles does not have to identify a concrete institution as being a part of government. As a theory a priori it leaves this problem open. Any valid business cycle theory can rely on it precisely because the general theory of error cycles does not venture to solve this problem and because its validity does not depend on such a solution. Rather it is the very task of applications of the general doctrine to particular conditions to provide such a solution. This means that one has to identify particular instances of government intervention and spell out where precisely the illusion is manifested. As a result, there would be various specific error cycle theories (the economic aspect of which would be specific business cycle theories).[23]Our further discussion will nevertheless be confined to the narrow but important area of government meddling with money. The task will be to reconstruct the traditional Austrian business cycle theory as an application of the general theory of error cycles. Austrian business cycle theory has successfully stressed the role of money as an institution that is important for almost all market participants. It could elegantly explain the occurrence of clusters of errors, and the following discussion can rely entirely on this valuable insight. In accordance with the principle that widespread error cycles are an implication of government activity one has to focus on government meddling with money rather than on changes of the quantity of money per se. On this issue Mises and Rothbard were, of course, at least intuitively right. Rothbard (1993, pp. 850ff.) even properly discussed business cycles in his chapters dealing with government interferences in the economy.[24] However, we have seen that in essence his business cycle theory still followed the old Misesian lines. We now have to correct this remaining shortcoming by putting the old theory in our new terms.
A Reconstruction of Business Cycle TheoryThe Fraud CycleInflation is “the process of issuing money beyond any increase in the stock of specie” (Rothbard 1993, p. 851). Thus, either it consists of an increase in fiat money or an increase in titles of ownership and money without a corresponding increase of money in the hands of the issuing agency. The first technique is applied, for example, when government central banks print new paper money. The second technique is usually called fractional-reserve banking. In both cases, inflation is a form of aggression against the property of some market participants, and both forms of inflation can be fruitfully analyzed when we ask whether the inflation is perceived or not perceived (in the case of fraud). Our further investigation has to begin from this crucial distinction. Either inflation is perceived or it is not.[25] Let us first discuss the latter case.Inflation makes future selling prices higher than they otherwise would have been. If the entrepreneurs do not anticipate this they will not bid higher interest rates on the loan market into which the new money sooner or later will be poured. Therefore, the new money will be employed to finance some other additional projects. Thus, more investment projects are begun than can ultimately be completed, for the quantity of the factors of production has not increased. Merely the quantity of fiat or fiduciary money has increased without the market participants noticing it. However, sooner or later the fraud will be detected. Then those projects will be abandoned that cannot be completed and only the most important (that is, the most profitable) projects will be further pursued.One easily recognizes that the above description of the fraud cycle is exactly what the traditional Austrian business cycle theory is about. Yet, we have to qualify the traditional account in one respect. It is not the mere increase in the quantity of money that leads to the fraud cycle, but government activity. Government meddling with money is, to be sure, not fraudulent per se, but as we shall see it is nevertheless the necessary condition for fraud-induced business cycles. Before we demonstrate this assertion let us briefly point out the fact that government meddling with money, at least, facilitates fraud. First, as government is the monopoly owner of the whole judicial and police apparatus there are no effective means left to control the activities of banks and fiat money producers. Second, it is the proclaimed goal of central banks to reduce unemployment through inflation. This is possible only if the rest of the market participants remain ignorant about the inflation (Mises 1980c). In order to attain their self-proclaimed ends, central banks must try to deceive the other market participants. Third, as inflation can only benefit some market participants at the expense of all others, it must be hidden from the distrusting public. The fraud cycle is therefore likely to recur as long as and insofar as government meddling with money takes place. It is the very purpose of monetary interventions to commit fraud on large numbers of the market participants.Now, one could insist that fraud is not a feature particular to government. Even on the free market there could be counterfeiters and fraudulent bankers holding only fractional reserves for the money substitutes they issued. This is true. However, such instances could never be sufficient to establish a business cycle theory. Let us recall that any such theory has to explain why there is a cluster of errors and why this cluster of errors is likely to occur again. Pointing to the possibility of fraud on the free market does not solve these problems. At best, one can in this manner explain clusters of errors, but one invariably fails to explain their recurrence.Imagine a commercial bank that has been brilliantly managed for four generations and has been able to expand its activities over a large area. Suppose further that the next heir is an utterly evil person who abuses the confidence of his customers. He commits fraud by holding only fractional reserves. Certainly this leads to a relatively general error cycle. Many market participants are affected when he eventually goes bankrupt because his fraud created a cluster of errors. We could consider an even worse case by supposing that the evil heir convinces some, or even all, of his fellow bankers to do the same thing. This would further enhance the resulting cluster of errors and make for a devastating crisis. The crucial question remains: what about the recurrence? Here the contention that the business cycle could be a free-market phenomenon invariably fails. It is inconceivable that, as long as the other market participants consider the activities of those bankers to be criminal acts, they may continue. Other bankers will take their place, and as banking is no fraudulent business per se we cannot infer from this large-scale crime that it has to occur again. Only if the other members of society think, for whatever reasons, that those activities were basically unobjectionable, can embezzlers go on and set out for the next fraud.Here, one last objection can be advanced, since we qualified our statements by saying “as long as the other market participants consider the activities of fractional-reserve bankers to be criminal acts.” This statement almost forces one to ask so what? Everybody has the right to think whatever he wants. On the free market nobody is told how he should think about the conduct of other people. How, then, could one deny that such widespread error is likely to recur on the free market?Indeed, if this were right then the business cycle could conceivably be a free-market phenomenon. Yet the argument is completely misdirected. For the difference between a free society and a society that is obstructed by government is precisely what the members of society think on issues like this one. The free market is not something that is established once and for all and independently of the beliefs that are held by the public. It is, rather, actions inspired by certain unjust beliefs that constitute governments, just as the free market is a manifestation of certain just beliefs. If fractional-reserve bankers go unpunished because the market participants believe this business to be legitimate then there is, ipso facto, government.[26] Fractional-reserve bankers then are persons who may permanently violate the property rights of other people. Therefore, once fractional-reserve banking becomes an institution, it is an instance of government.
The Illusion Cycle I: Fractional-Reserve BankingThe fact that unveiled inflation can be tolerated by the market participants merits further consideration. For, this will reveal that business cycle theory has a much larger scope than could be assumed by simply considering the fraud-induced business cycle that, in fact, was the subject matter of traditional business cycle theory. Unveiled inflation can take the form either of additional issues of fiat money or of fractional-reserve banking. Let us discuss the latter case first.The effects that the fiduciary issues of fractional-reserve banks will have on the price structure can be anticipated. People can adjust their activities to the distribution that will occur under this inflationary influence. If the market participants take account of the forthcoming inflation, they need not anticipate every single effect it might produce. It would be entirely sufficient that, in incorporating inflation into their plans, they are no less successful than in reckoning with other influences. Insofar as this is the case, inflation brings about “only” redistributions of income. But there is no fraud-induced business cycle. Does this mean, however, that there is no business cycle at all? Let us recall that the existence of a business cycle requires that a widespread error occur. It does not matter when this error is detected. We can content ourselves with the certainty that sooner or later it must be detected.What then is the widespread error in the case of fractional-reserve banking? Here two claims can be made. The first is that fractional-reserve banking is, from the outset, doomed to fail. The second is that it is a mere device for enforced redistribution. As a monetary system it has no advantages over a 100-percent coverage of money substitutes. Its only real purpose is to benefit some people at the expense of other people. As a consequence, it can never benefit the majority of the market participants. If these statements are right then it would have to be conceded that adherence to this system is based on an illusion. The illusion of the market participants would be to believe that fractional-reserve banking is something else than a part of government, that it serves something else than the exploitation of one part of the population by another part. As we have outlined in our general argument above, the conscious toleration of inflation cannot mean that the majority of market participants think that they are robbed. For, in this case, they would immediately stop it. Rather, they must think that continued inflation is, for whatever reasons, in their interest. Thus, the customers of fractional-reserve banks may think themselves benefited by this system because it permits lower interest rates on loans and interest rates on demand deposits, and because abolishing it would condemn the banks to bankruptcy. This is precisely the illusion in question. Indeed, interest rates are not generally lowered by an increased quantity of money. In the first part of this article we have shown why this is so: if the entrepreneurs anticipate the inflation, they will bid higher interest rates for the credit offered on the market. Moreover, even if inflation was not anticipated and interest rates were pushed below the level, they would otherwise have reached the conclusion that this would not benefit the bulk of the public. For, in this case, the fraud-induced business cycle that we described in the previous section would ensue. Furthermore, in respect to the interest paid on demand deposits, one has to remark that this measure can never be to the advantage of the majority. For interest on demand deposits becomes possible only by robbing some people. And interest is only a fraction of the loot, the rest goes to the fractional-reserve banks. Thus, if everyone has a demand deposit then the banks are the only market participants who profit systematically from the possibility of fiduciary issues. Finally, it is also an illusion to believe that a fractional-reserve system can live on forever. A fractional-reserve bank can increase its profits as long as it manages to issue further quantities of fiduciary money substitutes.[27] The banker knows that he may not exaggerate his issues, but he does not know where the limit is. If he does not venture to explore them then his competitors will.[28] Yet with each additional fiduciary issue the reserve ratio of the banks shrinks, and they become ever more vulnerable to unforeseen events. Eventually, the slightest deviation from what has been expected will suffice to bring about a collapse of the whole banking system.Conscious toleration of fractional-reserve banks implies that a majority of the market participants has fallen prey to an illusion. However, sooner or later they must discover their error as in the case of the fraud-induced business cycle we discussed before. Hence, what we face here is a second type of business cycle. The first type, which covers the traditional Misesian or Austrian business cycle theory, corresponds to the commonsense observation that outright fraud must eventually be detected. This second type, by contrast, suggests a conclusion that we know from the analysis of socialism, namely, that unjust institutions cannot last forever. By the very logic of action, they must either grow and thus destroy society or be abolished in a crisis-like situation. The eventual crisis of unjust institutions may therefore be interpreted as being part of a long business cycle.[29]
The Illusion Cycle II: Central Banking and Option ClausesAlthough an embezzler cannot avoid that the nature of his activities will sooner or later be detected, he can try to keep the show going for a while by extending the illusion on which his activity is based. This endeavour is central to the development of monetary institutions for the last three centuries. It has been aptly expressed by the term progression theorem.[30] The theorem states that the problems inherent in fractional-reserve banking cannot be solved by any technical devices like the pooling of money reserves, deposit insurance, option clauses for redemption, etc. These devices merely shift those problems to another level and, at the same time, make them even worse. The only real solution would be to abandon fractional-reserve banking altogether.This is most obvious in the case of the pooling of money reserves. As it is not the bigger money pool but the pooling itself that benefits the banks, this technique brings only temporary relief. The individual banks now are capable of meeting demands for redemption that, before, would have depleted their vaults. However, access to a bigger money pool permits the banks to further increase their issues of fiduciary money substitutes. Sooner or later a limit will be reached again where the slightest wrong speculation of any major market participant causes bankruptcy of the whole banking system. The difference is that the losses incurred by the depositors will be much higher. Deposit insurance schemes principally have the same effect. What benefits the fractional-reserve banks (and what obscures for a while their inherent bankruptcy) is not the insurance itself but its introduction. Again, by a technical device, the banks may increase their issues beyond those limits that were set to them before. But once the new limits are reached, the old problem reappears on a larger scale. The supposed remedy proves to be a Trojan Horse.Of course, the case is not different with option clauses. Here too it is not the option clause itself but its introduction that brings (temporary) relief. Yet, the advocates of fractional-reserve banking object that people might be willing to engage themselves in contracts providing for option clauses. This view, however, is entirely futile. It is absurd to call people willing to leave their money in bank accounts with option clauses “depositors.” For what these people in fact do is lend their money to the banks for the time specified in the option clause. They are not depositors but lenders of money. If the option clause provides for three months then the money “deposited” is in fact a three-months credit. If the clause provides for nine months we have a nine-months credit. If no period is specified then the money on the deposit account is not credit at all but a gift to the bank. The crucial point is, however, that in either case the problem of fractional-reserve deposits remains untouched. If the market participants left their money in demand deposits covered by option clauses, then there would be no fractional-reserve banking at all. All transactions of the banks would then be pure credit transactions. But what about the money that the market participants desire to use in their current transactions? Do they have to keep it under their pillows? Or may they leave it with some banker? And, if they choose the latter, does the banker have to keep the entire amount or may he lend out parts of it? These questions still remain. Hence, considering the case for option clauses more closely one discovers that, as a matter of fact, it does not relate to fractional-reserve banking at all.No pooling, no insurance, and no option clauses can undo the inherent bankruptcy of fractional-reserve banks. The so-called “problems” of the latter all boil down to this fact. The only way to solve these “problems of bankruptcy” is to recognize, first of all, that there is bankruptcy and then to liquidate the bankrupt enterprises and abolish the whole fractional-reserve system.
The Illusion Cycle III: Fiat MoneyA final “solution” for the bankruptcy of a fractional-reserve bank is to permit it to refuse redemption of its fiduciary issues. This would be a clear violation of the property rights of its customers, to be sure, but this is not the point we have to deal with here. For our purposes the important fact is that a fiat currency may arise in this way. Through the breach of contract (and, by the way, only through the breach of contract) a money substitute may become a money. Moreover, it is evident that such an event can only happen if the members of society have fallen prey to an illusion about the real nature of this event. They must, for whatever reason (for example, because they think that government has to regulate money) believe that something else than mere aggression is at stake. We are faced with the question of whether an institution that is built on an illusion could persist on the free market, or whether sooner or later the illusion must fade away by the logic of action. The latter is indeed what reflection will show. We shall see that a fiat money sooner or later will be driven out of the market.[31]Why is a currency driven out of the market? In general terms we might say, because the market participants discover that the employment of this currency is less useful than the employment of another currency. They do know a better alternative. The utility of a currency surely depends on the facility with which it can be handled. Therefore, those currencies that are, by virtue of their physical qualities, most proper for indirect exchange will drive all other currencies out of the market (Menger 1976; 1985).But what are the specific qualities of paper money (or, possibly, of electronic entries in an Internet account)? Let us first compare the use of fiat money with the use of metallic currencies on a free market. Here fiat money has one decisive disadvantage; namely, that it can be used only for a limited time and only for monetary purposes—at least if we abstract from such minor and destructive uses as papering walls or heating rooms. By contrast, metallic currencies can be used almost indefinitely and they always find other employments that do not prevent them from being used again as a medium of exchange. From this it follows for the competition between, for example, gold and a paper currency that gold can never be entirely driven out of the currency market, whereas the paper currency can. For even if gold were temporarily abandoned as a currency it would still have market prices per unit that would render its reintroduction as a currency worthwhile. On the other hand, once a paper currency is driven out of the market, its low commodity value would render any use as a currency impracticable. Thus, once driven out of the market, paper can never come back as a currency, whereas gold could do so very easily. This fact makes the use of paper currencies much more precarious than using gold. As soon as people realize this specific danger of the use of paper it is immediately abandoned as a currency. The ultimate failure of fiat money on the free market can be interpreted as the last phase of a very long business cycle.However, the currency market today is no free market but a market in which governments intervene in favor of their paper currencies. Paper is legal tender and the only currency in which taxes may be paid, and the use of precious metals as currencies is systematically obstructed. There are sales taxes on gold and income taxes on yields from gold hoards; banks are not allowed to offer gold-based accounts; no private coinage is permitted; and it is very unlikely that contracts running in terms of gold would ever be enforced by government courts and police (Sennholz 1985, pp. 22ff., 80ff.; White 1989, p. 64). These government institutions keep paper monies in circulation. However, they also create unresolvable problems, which must sooner or later end up in a crisis. In fact, if a paper currency is firmly established on a market there is an irresistible temptation to use it for the only purpose it specifically serves; namely, to finance government and to bail out bankrupt market participants. Let us focus on the latter possibility. Because the market participants know that they can be bailed out, at least the bigger firms will incur undue risks in their operations. Benefiting from zero-cost assurance, they have a systematic incentive to overstep the boundaries of sound business and reap additional profits without the risk of incurring losses. A small firm, it is true, might go bankrupt without danger for the political establishment. But the bankruptcy of a big corporation will not go without public protest and pressures for help. Thus, the very possibility to bail out some people brings about situations in which bailouts are dearly needed. Having established a paper currency, the government faces the challenge to bail out major parts, and possibly the whole, of the national economy. This challenge cannot possibly be met without leading to hyperinflation and economic breakdown. There is but one recourse left—to regulate the operations of the firms. But this intervention prevents a rational allocation of resources. The more businesses are regulated the more it becomes impossible for the entrepreneurs to discern the most-needed, and thus most-profitable, investments. It becomes more and more impossible to maintain, or extend, the present structure of production. The economy turns down. Again, we have ultimate failure at the end of a very long business cycle.In conclusion, let us emphasize that the use of money is an essential feature of any civilization. Monetary approaches to business cycle theory, and especially the Austrian one, have been most successful. Our analysis has stressed two major shortcomings of this approach. The first one is that the formulation of the theory is not general enough. Any business cycle theory must be grounded in a general theory of error. Second, the tacit general theory underlying the traditional business cycle theory is fallacious as it tries to explain error as a consequence of preceding events. By contrast, we have tried to show how a general theory of error cycles can be developed along essentialist lines. Recurrent clusters of errors can be deduced from the existence of government activities. This is because the latter can be interpreted as manifestations of error—which sooner or later will lead to crises. There are many specific error cycles: the monetary business cycle, the military-imperialistic cycle, the social security cycle, etc.As a by-product, our analysis provides a clearcut answer to a question that has plagued Austrian business cycle theory for a long time. If it were true that an increase in the quantity of money per se would set in motion the trade cycle then this would hold true for increases of the quantity of specie as well. Thus, even on the free market there would be a built-in source of business cycles calling for some remedy—possibly through government intervention. However, we have seen that the Austrian business cycle theory does not need to rely upon such an account. It does not have to claim that recurrent clusters of error stem from monetary changes. Rather, they can be deduced entirely from a constant feature of modern societies; most importantly, the existence of governments. It is not money but government intervention that accounts for the business cycle.
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Human Action: A Treatise on Economics. Auburn, Ala.: Ludwig von Mises Institute.de Molinari, Gustave. 1849. “De la production de la sécurité.” Journal des Économistes 22.Nock, Albert J. [1935] 1994. Our Enemy, The State. San Francisco: Fox and Wilkes.Oppenheimer, Franz. [1907] 1990. Der Staat. Berlin: Libertad.Revel, Jean-François. 1992. Le regain démocratique. Paris: Fayard.Rothbard, Murray N. 1978. For A New Liberty: The Libertarian Manifesto. 2nd ed. New York: Macmillan.———. [1963] 1983. America’s Great Depression. 4th ed. New York: Richard and Snyder.———. 1982. The Ethics of Liberty. Atlantic Highlands, N.J.: Humanities Press. Reprinted in 1998 by New York University Press.———. [1963] 1990. What Has Government Done to Our Money? Auburn, Ala.: Ludwig von Mises Institute.———. 1991. The Case for a 100 Percent Gold Dollar. Auburn, Ala.: Ludwig von Mises Institute.———. [1962] 1993. Man, Economy, and State. 3rd ed. Auburn, Ala.: Ludwig von Mises Institute.Salerno, Joseph T. 1990. “Ludwig von Mises as a Social Rationalist.” Review of Austrian Economics 4: 26–54.———. 1991. “Two Traditions in Modern Monetary Theory.” Journal des Économistes et des Études Humaines 2, no. 2/3.———. 1993. “Mises and Hayek Dehomogenized.” Review of Austrian Economics 6, no. 2: 113–46.———. 1995. “Ludwig von Mises on Inflation and Expectations.” Advances in Austrian Economics 2b: 307ff.Schultz, T.W. 1975. “The Value of the Ability to Deal With Disequilibria.” Journal of Economic Literature 13, no. 3: 827ff.Selgin, George A. 1990. Praxeology and Understanding. Auburn, Ala.: Ludwig von Mises Institute.Sennholz, Mary. 1985. Money and Freedom: Essays in Honor of Ludwig von Mises. Spring Mills, Penn.: Libertarian Press.Shmanske, Stephen. 1994. “On the Relevance of Policy to Kirznerian Entrepreneurship.” Advances in Austrian Economics 1.Skousen, Mark. [1977] 1996. Economics of a Pure Gold Standard. 3rd ed. Irvington-on-Hudson, N.Y.: Foundation for Economic Education.Spencer, Herbert. [1884] 1981. The Man Versus the State. Indianapolis, Ind.: Liberty Fund.———. [1851] 1995. Social Statics. Reprint by Schalkenbach Foundation.de Soto, Jesus Huerta. 1994. Estudios de Economía Política. Madrid: Union Editorial.———. 1998. “A Critical Note on Fractional-Reserve Banking.” Quarterly Journal of Austrian Economics 1, no. 4 (Winter): 25–49.Wieser, Friedrich. 1924. Theorie der gesellschaftlichen Wirtschaft. 2nd ed. Tübingen: Mohr.———. 1926. Das Gesetz der Macht. Vienna: Julius Springer.White, Lawrence H. 1989. Competition and Currency. New York: New York University Press.[1] See in particular Mises (1928; 1998, pp. 550ff.); Hayek (1929; 1931); and Rothbard (1993, pp. 854ff.; 1983, pt. 1).[2] See in particular Lucas (1987); Schultz (1975); and also Shmanske (1994).[3] Emphasis added. See also Mises (1998, pp. 584f.) and Garrison (1991, p. 95).[4] For a brilliant critique of other approaches see Rothbard (1983, pp. 39ff.); see also Mises (1998, pp. 559f., 580ff.); Hoppe (1983, pp. 64ff.); Garrison (1989; 1991).[5] This explanation is manifest in the use of the imaginary construction of the evenly rotating economy for the explicit purpose of analyzing “the problems of entrepreneurship and of profit and loss” (Mises 1998, p. 248). It is also evident in statements like “[changes in valuations] are the source from which entrepreneurial profits and losses stem” (ibid., p. 534) or “new data emerge again and again and divert the trend of prices from the previous goal of their movement toward a different final state” (ibid., p. 547).[6] For the distinction between risk and uncertainty see Knight (1921). Mises improved upon Knight’s argument by introducing the distinction between class probability and case probability (see Mises 1998, pp. 105ff.).[7] The quoted passage is translated in Mises (1943, p. 251).[8] See also the analogous argument (Mises 1943, p. 547f.).[9] Hayek has further elaborated this kind of reasoning in terms of a mechanistic relationship between prices. See in particular Hayek (1939).[10] One could argue that, from Mises’s methodological point of view, business cycle theory has to rely precisely on this assumption. For, according to Mises, error and its offspring—profit and loss—has to be analyzed by a comparison to the evenly rotating economy (ERE); that is, to a state of affairs in which no error occurs (Mises 1998, p. 248). In this case, it is true; a “business cycle” would result even if only some market participants did not anticipate all effects of an ongoing inflation. For even some few errors represent a “cluster” in comparison to a situation of no error at all. However, as the market participants in the ERE are admittedly not acting human beings, but reacting automatons, this construction is even more questionable than the assumption that all market participants anticipate all the effects of inflation—which is at least logically conceivable.[11] See also Mises (1980b).[12] See also Rothbard (1990, p. 60). A variant is Mises’s claim that a slight and continuous increase of money and money substitutes can be handled by entrepreneurs (see Mises 1998, p. 574). Of course, this represents merely an additional problem for his consequentialist explanation of error. For now one has to explain why constant inflation does not or even cannot lead to errors while one still has not explained why irregular inflation must lead to error.[13] For the view that business cycle theory has to be abandoned, see for example Eucken (1989, p. 180). Eucken claims that each business cycle requires an individual historical account.[14] On the psychological aspects of the error phase, and to what extent it goes hand-in-hand with mass irrationality and even insanity, see Cantor’s (1994) brilliant study.[15] A discussion of this change in the character of institutions can be found in Wieser (1924). Wieser’s analysis of the rise and fall of institutions used Menger (1985, pt. 2) as a foundation.[16] For the nature of government as being able to violate private property, see, for example, Rothbard (1998). Even though it is a very important question as to how such an institution could ever emerge, this topic need not be addressed here. Our purpose is more limited, thus we can take the existence of government as an ultimate given and confine ourselves to analyzing its implications. Moreover, there are already excellent investigations into the emergence of government. See especially Oppenheimer (1990); de Jouvenel (1972); Nock (1994); Krippendorf (1985); Higgs (1987).[17] See on this point, among earlier authors, Bastiat (1983, pp. 148ff.; 1986, pp. 227ff.); de Molinari (1849); Spencer (1995, pp. 175ff.; 1981, pp. 149ff.). Among later authors, see in particular Rothbard (1978; 1982); Hoppe (1987; 1989; 1993a).[18] Recently, another French author has forcefully captured this aspect of aggression in his analysis of communism: “The origin of communism is not situated in history, not in the concrete, not in the ‘praxis,’ but, quite to the contrary, in the human capacity to ignore it” (Revel 1992, p. 262). Revel also gives a splendid quote from Saint Augustine, Confessions, X, 34: “So much is truth beloved that whoever loves something else wishes it to be the truth.” See also Hoppe (1987; 1989; 1993b, ch. 4, esp. pp. 102ff.); Baader (1997). In this context one is also reminded of the Emperor’s new clothes, or of Plato’s tale of the ring of Gyges.[19] See de La Boétie (1993); Hume (1987b, pp. 32ff.); see also Wieser (1926, pp. 5ff.); and Mises (1998, pp. 188ff.).[20] See Mises (1998, ch. 26) and Rothbard (1993). On Mises’s calculation argument see the important contributions of Salerno (1990; 1993). See also Hoppe (1996) and Hülsmann (1997).[21] See on this important point the pioneering work of Rothbard (1993, pp. 542ff., 825ff., 830ff.) and Klein (1997).[22] In other words, we deny that there is a kind of inescapable escalation mechanism of government interventions, with one intervention leading necessarily to the next one. For different approaches to explain interventions as the consequence of other interventions, see Condillac (1795, pp. 316ff.); Spencer (1981, pp. 45f., 79ff.); Mises (1977, pp. 150–51); Grinder and Hagel (1977, pp. 69ff.).[23] See, for example, Mises’s (1998, p. 586) observations on the “corn-hog cycle” or Hoppe’s (1993c, ch. 3, pp. 61ff.) pioneering study on the dialectics of domestic and foreign government activity.[24] Also see on this point also de Soto (1994, pp. 157f.). Mises (1998, p. 573) asserted that business cycles could be a market phenomenon, but that “today credit expansion is exclusively a government practice” (ibid., p. 794, emphasis added).[25] For an analysis of fractional-reserve banking on the basis of this distinction, see Hülsmann (1996a, pp. 213ff.; 1996, pp. 35ff.). For a critique of fractional-reserve banking see also Rothbard (1991) and de Soto (1998).[26] See Rothbard’s analogous statement: [I]t would be empty and meaningless for [someone] to trumpet that he does not “really” own some or all of what he has produced . . . for in fact the use and therefore the ownership has been already his. [Everyone] in natural fact, owns his own self and the extension of this self into the material world, neither more nor less. (1982, p. 34)The same thing holds true for Rothbard’s brilliant anti-slavery argument: “[A man] cannot transfer himself, even if he wished, into another man’s permanent capital good” (ibid., p. 38). Someone claiming that the interdiction of fractional-reserve banking would infringe upon man’s freedom of contract would have to hold the defense of slavery to be a like infringement.[27] “Where competition enters into the problem between banks otherwise on equal footing, the bank which runs closest to the danger line in respect to the size of its metallic reserve without actually impairing public confidence will make the largest profits” (Conant 1905, pp. 71f.; quoted in Skousen 1996,p. 38).[28] Therefore, competition between fractional-reserve banks “would . . . not hinder a slow credit expansion” (Mises 1998, p. 443). For the implications of this point see Skousen (1996, pp. 136f.). While Mises championed fractional-reserve banking he did not do so here because he wanted the money supply to be flexibly adjusted to the “needs of trade.” See on this point de Soto (1998).[29] See again Hoppe (1993b) and the literature quoted there. This gives also an excellent account of observations like the following one made by F.A. Hayek: “The one thing which, we will admit, has surprised me about the boom of the last twenty years is how long the effectiveness of resumed expansion in restarting the boom has lasted” (1983, p. 40). In fact, the difficulty that Hayek encountered stemmed from his attempt to explain the ongoing illusion cycle during the 1970s with the help of the traditional Misesian theory.[30] The term has been coined by Salerno (1991, p. 371). For the content of the theorem see Rothbard (1990).[31] The following analysis of currency competition revises in some respects the (consequentialist) argument in Hülsmann (1996b, pp. 255ff.).
Volume 17, No. 2 (Summer 2014)ABSTRACT: This paper identifies merger waves as parts of Austrian-type business cycles. According to Austrian business cycle theory, when loan rates are reduced below their natural level through bank credit expansion, this falsifies the monetary calculation of capitalist-entrepreneurs, and investments are initiated that calculation showed were not profitable before the interest rate reduction. Since there are not enough resources in the economy to complete the new projects, businesses must increasingly withdraw the resources from other companies. Thus, this paper concludes that the increase in investment activity and the resulting “resource crunch” cause a merger wave that helps prolong the boom phase of the cycle. The merger wave ends when the credit expansion is not sufficient to sustain the economic boom, and the bust phase begins. Conversely, this paper concludes that if the fiduciary media do not enter the economy through the loan market to finance business investment, there is no pronounced and sustained increase in merger activity.
KEYWORDS: Austrian business cycle, merger waves, Austrian, neoclassical, behavioralJEL CLASSIFICATION: B53, E32, G341. INTRODUCTIONOne of the main puzzles in contemporary mainstream financial economics is: why are there time periods of frantic mergers and acquisitions (M&A) activity known as merger waves? While in this literature much work has been done on the causes of takeovers and restructuring activity at the firm and industry level, relatively little work has been done on the causes of economy wide merger waves. Moreover, the latter is divided in two rival camps: behavioral and neoclassical.Jimmy Saravia (jsaravia@eafit.edu.co) is Professor, Grupo de Investigación en Banca y Finanzas, School of Economics and Finance, Center for Research in Economics and Finance (CIEF), Universidad EAFIT, Medellín, Colombia. The author would like to thank an anonymous referee and the editor of this journal for valuable comments and suggestions.
According to the “behavioral hypothesis” of merger waves, during bull markets investors irrationally misprice stocks across the board and rational managers, taking advantage of misperceived merger synergies, use their overvalued stock to acquire the resources of less overvalued or undervalued companies. The main proponents of this theory are Shleifer and Vishny (2003). On the other hand, the “neoclassical hypothesis” maintains that merger waves are rational responses by market participants that occur when economic shocks (economic, regulatory, or technological), which call for reorganization at the industry level, overlap with low transaction costs that take place because of the presence of high “capital liquidity.” The role of capital liquidity is to reduce the costs of reallocating the assets, thus permitting a large volume of transactions to occur in a relatively short period of time. The main proponent of the neoclassical theory is Harford (2005).
There is a growing body of empirical literature that aims to test the hypotheses of the neoclassical and behavioral schools, which has yielded mixed results. For instance, while Harford (2005) finds that during the second half of the 1990s M&A activity was clustered in certain industries which he identifies as being impacted by economic shocks, and that simultaneously there was a positive correlation between high capital liquidity and M&A activity, Gärtner and Halbheer (2009) find that the 1990s M&A wave cannot be attributed to a temporary intensification of M&A activity in a small group of industries. On the other hand, while Rhodes-Kropf et al. (2005) and Dong et al. (2006) find evidence in favor of the behavioral theory using measures of firm overvaluation, Harford (2005) presents several pieces of evidence that contradict behavioral theory. In particular, Harford finds a strong positive correlation between M&A activity financed using cash and M&A activity financed using stock, and presents evidence that both increase during the M&A wave. Moreover he finds that, at the firm level, being a bidder in a “stock merger” increases the likelihood of being cash buyer of divisions of other companies during the M&A wave.
Now, from the Austrian perspective the causes proposed by these two schools (i.e., overvaluation of stocks or economic shocks followed by high capital liquidity which reduces transaction costs) cannot be accepted as ultimate causes of M&A waves. Although these factors may plausibly have an influence in the direction of the actual market process during an economic boom and the accompanying M&A wave, the causes of their occurrence can be explained in turn at a more basic level in the context of the Austrian business cycle theory (ABCT).
Following standard Austrian theory step by step, in this paper I identify M&A waves as parts of Austrian-type business cycles. The argument is briefly as follows. When bank credit expansion reduces loan rates below their natural level, capitalist-entrepreneurs will tend to undertake more investments than can be completed with the resources available in the economy. The initiation of these projects launches an unsustainable economic boom, and due to the escalating scarcity of resources aggravated by household overconsumption, businesses must increasingly withdraw the resources from other companies. I conclude that this increase in investment activity, together with the accompanying “resource crunch,” causes the M&A wave. If this logical deduction is correct, then the two standard theories in mainstream financial economics mentioned above are leaving out important causes of the M&A wave, such as the increase in investments and the scarcity of resources during the economic boom. Also note that in this context, the phenomenon of stock overvaluation highlighted by the behavioral school can be explained, as a result of the reduction of interest rates (when interest rates are artificially pushed downwards, asset prices will tend to artificially increase), and also as a result of the increased demand for the resources that the stocks give title to. On the other hand, the high “capital liquidity” pointed out by the neoclassical school is explained in the context of ABCT as a result of bank credit expansion.Theoretical variations on the neoclassical and behavioral themes are provided by Jovanovic and Rousseau (2002), Rhodes-Kropf and Viswanathan (2004) and Gugler et al. (2012). However, since these theories are susceptible to the same critique above—namely that from the Austrian perspective the causes put forward by these theories cannot be accepted as ultimate causes of M&A waves, and that such causes in turn can be explained at a more basic level in the context of the ABCT—in the interests of brevity I do not discuss them here.
In considering the Austrian theory of M&A waves presented in the next section, it is important to keep in mind that the entrepreneurial function in the theory is provided by the capitalist-entrepreneurs. That is, by “the speculators, promoters, investors and money lenders” who determine “the structure of the stock and commodity exchanges and of the money market” and the “allocation of capital to firms and industries.” (Mises, 1998, p. 704; Rothbard, 1991, p. 58). Moreover, there is an important difference between entrepreneurship and management. The function of the entrepreneur is “to appraise—to anticipate—future prices, and to allocate resources accordingly” (Rothbard, 1991, p. 66, emphasis in the original). In contrast, the managerial function is a “subsidiary service.” Thus, when in this paper it is stated that corporate managements undertake investments, it is important to bear in mind that they do so in execution of the tasks delegated to them by the capitalist-entrepreneurs (Mises, 1998, p. 703).
The rest of this paper is organized as follows: in section 2 I briefly go over the main arguments of ABCT and indicate how M&A waves rise and wane. In section 3, I provide an illustration of the theory by examining the history for the United States in the last 20 years. In particular, I draw attention to the fact that when fiduciary media entered the economy through the loan market to finance business investment, Austrian business cycles accompanied by M&A waves occurred, but that when newly created money did not enter the economy through the loan market to finance business investment, there was no pronounced and sustained spike in merger activity although stock prices and liquidity were at historic highs. I conclude in section 4 by summing up and reinterpreting some of the findings of the behavioral and neoclassical schools in light of the Austrian theory.
- M&A WAVES AS PART OF ABCTAccording to the ABCT, the business cycle is caused by a reduction of the interest rate below its natural level when newly produced fiduciary media, created by the financial system, enters the economy through the loan market and falsifies the monetary calculation of capitalist-entrepreneurs and households (Mises, 1998; Hayek, 2008; Rothbard, 2009). This artificial reduction in the rates of interest has two effects which constitute the essential features of the Austrian business cycle: “malinvestment” and “overconsumption” (Salerno, 2012).
On the one hand, the artificial reduction of interest rates leads capitalist-entrepreneurs to believe that society has become thriftier and that the level of savings has increased, when in fact the interest rate is too low in comparison with society’s time preference. This in turn prompts them to overestimate the amount of resources available to invest and to begin more projects than can be finished with the available means of production. Moreover, the proportion of longer-term projects will increase relative to short-term projects as their present value will increase more due to the interest rate reduction, and as a consequence the structure of production is lengthened. This unsustainable lengthening of the structure of production constitutes the malinvestment feature of the inflationary boom. On the other hand, the fall in interest rates also falsifies households’ appraisals of their income and wealth. This comes about through what is called the “wealth effect.” As the inflationary boom proceeds and factors of production become more scarce, salaries are bid up and asset prices (such as stocks and real state) also go higher (Bagus, 2008). Thus households feel wealthier and more optimistic about their future income streams. This causes them to over-consume, save less and even go into debt as they mistakenly believe they can afford it. This constitutes the overconsumption aspect of the Austrian business cycle (Salerno, 2012).
Overconsumption aggravates even more the erroneous assessment regarding the availability of investable resources made by the capitalist-entrepreneurs, and the scarcity of all kinds of resources eventually becomes evident as prices for those resources start to soar. As businesses increase their demands from the several resource and labor markets, these ultimately become depleted and the resources, if available, of relatively lower quality and expensive. Therefore, firms must increasingly withdraw resources from other companies.
As pointed out by Klein (1999) company managements supplement their normal forms of investment (i.e., capital expenditures and R&D) by acquiring the resources of existing firms through merger. Under normal conditions, one important reason why the latter occurs is that the acquisition of an already established firm or company division may be the best and quickest means to undertake an investment opportunity when the “capacities of the existing managerial personnel of the firm” are not sufficient to embark on the investment through the purchase of new plant and machinery, that is, through internal growth (Penrose, 1995, pp. 45–49 and 127–131). Thus, as investment activity increases in the earlier stages of the boom, it is logical to deduce that M&A activity will increase as well, and this initiates the merger wave. However, as mentioned above the economy’s resources are not sufficient to complete all the projects. Thus the question that capitalist-entrepreneurs and their managements ultimately face is: what can be done to finalize the investments or at least to continue them one more period of time? Clearly, if resources are scarce and costly, it should become easier for capitalist-entrepreneurs and firm managements to see the operating economies that can result from eliminating duplicate facilities, and consolidating the marketing, purchasing and accounting operations. On the other hand, during the boom, synergy and economy of scale stories are easier to make and back with numbers. For example, a company that increases its productive capacity may find its sales force inadequate and that synergies can be achieved by merging with another firm with a strong sales force. Thus, in order to complete the projects, one solution can be either to purchase another company or sell one’s own firm to a business that has the resources to complement your investments. In addition, this would also have the advantage of reducing the number of firms competing for the same pool of resources.
I conclude that, facing a “resource crunch,” businesses must increasingly find it advantageous to merge with other companies. Therefore, during the inflationary boom, one should expect to see both an exceptionally high demand of resources in the different markets (manifested, for example, in a very low unemployment rate and high resource prices) and an unusually high level of M&A activity. Interestingly, the increased M&A activity also explains why past economic booms have seemed to last longer than one would expect if companies could only draw their factors of production from the different resource and labor markets. Without the possibility of extracting the necessary resources from other companies, many projects would need to halt in a relatively short period of time after their start due to a shortage of inputs. Under this scenario, many investments would quickly fail, the banks would become concerned about the quality of their loans and tighten credit standards earlier, and consequently the bust would occur much sooner. In contrast, by taking their resources from other companies through merger, capitalist-entrepreneurs and their managements can carry out their projects and postpone the bust for a while.
In this context, the economic, regulatory and technological shocks proposed by the neoclassical literature (Harford, 2005) have a role in determining in which industries the M&A wave is more pronounced. In particular, as Callahan and Garrison (2003, p. 74) have pointed out, “every bubble needs a story, which early investors can tell to later ones to justify rising asset prices,” and it is clear that technological innovation, such as the internet in the 1990s and episodes of deregulation, can serve this purpose. This is not to deny that an economic, regulatory or technological shock can prompt a legitimate reallocation of assets in an industry. Austrian theory demonstrates that, in the absence of bank credit expansion, capitalist-entrepreneurs relying on sound monetary calculation would proficiently undertake the reallocation of assets over time with some occasional errors, but nothing in the way of a manic episode with a clustering of entrepreneurial error ending in an economy-wide crisis. The important point is that, in a monetary regime in which bank credit expansion is allowed, the M&A wave should be more pronounced in those industries where there is a good story to justify the high asset prices. And a convincing economic, regulatory or technological shock can provide such a narrative.
The M&A wave ends with the Austrian-type business cycle, when the credit expansion is not sufficient to sustain the economic boom, which usually occurs when central banks finally detect in their aggregate measurements that price inflation is increasing sharply. At this point the authorities have two options, to continue stimulating the economy and risking a “crack-up boom” (Mises, 1998), or tighten monetary policy and let interest rates rise again. If the latter option is chosen, the overextended financial system becomes increasingly concerned as the errors committed in the boom become evident, credit standards are tightened and the crisis begins. As a result, consumption and investment plummet, unemployment rises and M&A activity falls.
Finally, it is important to point out that if the newly created fiduciary media do not enter the economy through the loan market to finance business investment and distort the structure of production, there is no Austrian-type boom-bust cycle. If so, there should be no pronounced and sustained spike in merger activity and the accompanying clustering of entrepreneurial error.
- HISTORICAL ILLUSTRATIONThis section provides an illustration of the Austrian M&A wave theory by examining the history of the United States in the last twenty years. During this period Austrian economists successfully identified in advance two Austrian-type business cycles developing in the U.S. economy (Thornton, 2013). Moreover, after each of the busts, Austrian economists such as Callahan and Garrison (2003) and Salerno (2012) provided detailed accounts about the two episodes as well as commentaries about the prospects for the future. Hence, in what follows I take it as a historical fact that there occurred two Austrian-type business cycles in the period under question, and therefore, my focus will be in indicating how M&A waves were a part of these boom-bust cycles.
First Business Cycle (from 1995 to 2002).According to Callahan and Garrison (2003), the first business cycle in the relevant period occurred between 1995 and 2002. In their paper, the immediate cause of the cycle is identified as the loose monetary policy of the Fed prior to the 1996 presidential elections. Moreover, a series of crises forced the Fed to continue with its expansive monetary stance through early 2000, even though the economy was showing signs of overheating. The low interest rates and fiduciary media created by the financial system falsified the capitalist-entrepreneurs monetary calculation, which in turn started to malinvest, notably in dot-com and telecommunication companies, but also in other sectors of the economy. Figure 1 shows the high levels of net private investment during the boomThe figure presents net investment rather than gross investment given that the former is a measurement of expenditure in excess of that required to maintain the existing capital structure.As can be seen, net investment peaked in 2000.
Figure 1. Net Private Domestic Investment: Net Fixed Investment (A560RC1A027NBEA). Source: FRED.The monetary stimulus also resulted in overall high stock prices, which peaked in March of 2000 (Figure 2) and through the “wealth effect” induced households to over-consume, produced a collapse in savings and an increase in household indebtedness. In particular, households reduced their personal savings rate from around 9 percent in the early 1990s to 4 percent in 1999–2000. Additionally, the increase in indebtedness is reflected in the increment in debt service payments as a percent of personal disposable income, which increased from 11 percent to close to 13 percent in the 1990s.Debt service payments as a percent of personal disposable income, Federal Reserve Economic Data (FRED), Federal Reserve Bank of St. Louis, Series ID: TDSP.
Figure 2. Wilshire 5000 Price Index. Source: FRED.Crucially, the capital consumption and malinvestment resulted in a shortage of resources and workers in the different industries. Callahan and Garrison (2003, p. 87) draw attention to the scarcity of resources in the dot-com sector:
There were too few resources available for all of the plans formulated and funded during the boom to succeed… There were shortages of programmers, network engineers, technical managers, office space, housing for workers, and other factors of production.
Finally, Callahan and Garrison indicate that the business cycle ended when Fed tightened monetary policy in 2000 and punctured the bubble. As a result, an economic recession ensued and the 1990s boom came to an end.
I conclude from the foregoing that as investment activity increased in the earlier stages of the boom (Figure 1), merger activity also increased as company managements supplemented their normal forms of investment (i.e. capital expenditures and R&D) by acquiring the resources of existing firms through merger. This initiated the M&A wave. Moreover, I deduce that the “resource crunch” described by Callahan and Garrison (2003) intensified the M&A wave of the late 1990s and that the increased M&A activity allowed the boom to persist for a while for the reasons stated in section 2. Finally, the M&A wave ended when the bust set in and the errors committed during the boom became manifest to most economic actors. As a result, some of the investments lost most of their value and others had to be liquidated. The extent of the M&A wave of the late 1990s can be illustrated with the help of Table 1 and Figure 3. As can be seen, the value of announced M&A transactions tripled from $676 billion in 1995 to $2,140 billion in 1999 and then fell considerably to $521 billion in 2002 once the bust set in. The wave is also reflected in the number of announced M&A transactions which increased from 11,206 in 1995 to 15,454 in 1998, and then fell to 8,670 in 2002.
Table 1. Announced Mergers & Acquisitions: USA, 1994–2013. Source: Institute of Mergers, Acquisitions and Alliances.Figure 3. Announced Mergers & Acquisitions: USA, 1994–2013. Source: Institute of Mergers, Acquisitions and Alliances.Second Business Cycle (from 2002 to 2009).The second Austrian-type business cycle in the period under study occurred between 2002 and 2009, and is described in detail by Salerno (2012). The Fed reacted immediately to the recession of the early 2000s by aggressively lowering interest rates and taking measures to expand the money supply. Notably, the Fed kept the federal funds rate under 2 percent for three years from December 2001 to November 2004. More importantly, there was a sharp reduction in 30-year conventional mortgage rates and adjustable mortgage rates, which combined with loose credit standards, resulted in a housing bubble that peaked in 2006. The monetary stimulus also caused a steep ascent in stock prices which continued go up until 2007 (Figure 2). These developments created a “wealth effect” that led households to overconsume and go into debt, as stated by Salerno (2012, p. 30):
Misled by their inflation-bloated balance sheets, households were induced to “cash out” some of their home equity and increase expenditures on consumer goods and services. In the expression of the day, people began “using their homes as ATM machines.” Households financed their increased spending on boats, luxury autos, upscale restaurant meals, pricy vacations etc., through fixed-dollar debt.
The wealth illusion also produced a reduction in saving. The personal saving rate as a percent of disposable income fell from slightly over 5 percent in early 2002 to 2 percent in 2005.See footnote 4 for the sources of data on the personal savings rate.
On the other hand, the extent of the malinvestments during the 2002–2009 boom-bust cycle is illustrated in Figure 1. As can be seen, after falling to $538 billion in 2002, net private domestic investment resumed its growth and reached a peak at $849 billion in 2006. As in the previous cycle, the boom came to an end as the Fed raised interest rates. On this occasion, the errors committed during the boom became dramatically manifest in the housing market. This had dire implications for the financial system as most of the housing investors were highly levered with bank credit and their mass defaults brought the prospect of the failure of many banks. This in turn triggered bank runs and financial instability, which prompted the federal government and the Federal Reserve to take unprecedented measures to prevent a financial collapse.
Importantly, in this second boom-bust cycle it is possible to discern the same pattern in M&A activity. As investment activity started to pick up again in 2003 (Figure 1), M&A activity also started to increase as company managements supplemented their investments in R&D and capital expenditures with mergers and acquisitions (Table 1 and Figure 3). Moreover, as the overconsumption described by Salerno (2012) and net private investment intensified, another “resource crunch” situation developed, which intensified the M&A wave. The mergers allowed the boom to continue for a while (see section 2). The M&A wave ended as the Fed tightened monetary policy, triggering the bust. As shown in Table 1 and Figure 3, the value of announced M&A transactions almost quadrupled from $521 billion in 2002 to $1,975 billion in 2007 and then more than halved to $879 billion in 2009. The M&A wave is also reflected in the number of announced M&A transactions, which increased from 8,670 in 2002 to 14,230 in 2007 and then fell to 9,648 in 2009.
Economic Stagnation (from 2009 to … ).Following the financial crisis, the Fed reacted aggressively with a series of Quantitative Easing (QE) programs that have boosted the monetary base at an unprecedented rate. In addition, the Fed reduced the federal funds rate to close to zero percent in December 2008—where they have been kept and are expected to be maintained for the foreseeable future—and has taken steps to bring down long term interest rates as well (the so-called “Operation Twist”). Although these measures have succeeded in re-inflating stock market price indices which have recently reached historic highs (Figure 2), on this occasion the stimulus has failed to restore the growth of bank credit expansion to the double-digit annual growth rates observed during the last two business cycles, Total Loans and Leases, percentage changes from a year ago, Federal Reserve Economic Data (FRED), Federal Reserve Bank of St. Louis, Series ID: TOTLL. and net private domestic investment has remained depressed with the 2012 figure 60 percent below the 2006 high of $849 billion (Figure 1). Thus, in the period after the financial crisis, the newly created money has not entered the economy through the loan market to finance business investment. Instead the money has been flowing to the financial markets to inflate the prices of financial assets and to finance trillion-dollar federal government deficits. Now, if the newly created money is not entering the economy through the loan market to finance business investment to distort the structure of production, there can be no boom-bust cycle of the Austrian type. Instead, Austrian theory indicates that there will be price inflation and wealth redistribution from the productive classes of society to those best placed to take advantage of the consequences of the inflation. Importantly, as pointed out in section 2 above, if there is no Austrian business cycle developing, there ought not to be a pronounced and sustained spike in M&A activity followed by a crisis that reveals a cluster of investment errors on the part of capitalist-entrepreneurs. Hence, contrary to the predictions of the neoclassical and behavioral theories of M&A waves, in a period such as the one at hand in which capitalist-entrepreneurs have temporarily lost their confidence in the reliability of economic calculation (Salerno, 2012), regime uncertainty is high (Higgs, 1997; id., 2012) and consequently investment activity is low, there should be no M&A wave even though (a) stock prices are being inflated to record highs through monetary policy (conflicting with the behavioral theory), and (b) strong economic shocks and dislocations overlap with unprecedented levels of liquidity in the stock markets (opposite to the neoclassical theory).
The conclusion of no M&A wave without an Austrian-type business cycle is consistent with the history of M&A activity in the period after the financial crisis. As shown in Table 1 and Figure 3, after falling to $879 and $982 billion in 2009 and 2010 respectively, there was a “dead cat bounce” in the value of announced M&A activity to $1,257 billion in 2011 before falling back down again to $987 billion in 2012. This see-saw pattern has continued with another increase to $1,144 billion in 2013. These figures are between 35 to 55 percent lower than the high reached in the previous cycle of $1,975 billion in 2007, so there are no signs of a merger mania when examining the value of M&A activity after the financial crisis. Additionally, a pronounced spike in the number of announced M&A transactions has also not occurred. After falling to 9,648 deals in 2009, the number of transactions gradually increased to 10,728 in 2011, and lately it has gone down to 10,327 in 2013—this latter number still 27 percent below the 14,230 figure reached in 2007.
- CONCLUSIONThe phenomenon of the business cycle, their accompanying M&A waves and the economic impoverishment they bring are not a feature of the free market as many economists have uncritically assumed. Instead, as the Austrian school maintains, these phenomena are the result of the way in which the monetary and banking systems have been historically organized. To prevent business cycles and M&A waves, the solution would involve a reform in which the reduction of interest rates below their natural level through bank credit expansion is ruled out.
Once an Austrian-type boom-bust cycle is under way, the behavioral school is correct, I believe, in that some of the M&A activity will occur as managers, taking advantage of misperceived merger synergies, use their overvalued stock to acquire the resources of less overvalued or undervalued companies. However, the cause of the radical mispricing of the stocks are not some mysterious “animal spirits.” Rather, it is the result of the falsification of the households’ and capitalist-entrepreneurs’ monetary calculations. This suggests that in addition to studying human behavior under conditions of uncertainty, behavioral economists should also study human behavior under false information about their wealth, income and investment prospects.
On the other hand, the neoclassical school has a point in indicating that economic, technological and regulatory shocks and excessive liquidity have a role in M&A waves. However, in the context of the ABCT the role of the shocks is to provide a story to justify the bubble as Callahan and Garrison (2003) have pointed out. In this sense, the bubble will tend to be more pronounced in those sectors where a more credible case for the boom can be made. Moreover, the excess liquidity is not something that just happens cyclically and endogenously in the free market. Instead, it is the result of the monetary intervention and the bank credit expansion that existing institutional arrangements allow. In another vein, the neoclassical school is too sanguine in supposing that M&A waves are an optimal response to certain disturbances and that capitalist-entrepreneurs are basically omniscient and never make mistakes. In fact, capitalist-entrepreneurs do make mistakes and under free market capitalism with sound money, entrepreneurs would still make some mistakes evenly over time. What needs explanation is why entrepreneurial mistakes tend to cluster and are identified at some points in time we call recessions. I submit that ABCT is our best explanation of why these clusters of entrepreneurial mistakes occur.
Ultimately, from the perspective of the Austrian school, the behavioral and neoclassical schools do not identify the underlying causes of M&A waves. Although the factors proposed may plausibly have an influence in the direction of the actual market process during an economic boom and the accompanying M&A wave, the causes of their occurrence can be explained a more basic level in the context of ABCT. Financial economists would do well to incorporate the insights of the Austrian school in their work; many of the puzzles of modern finance could be solved in this way.
Volume 17, No.1 (Spring 2014)J. Huston McCulloch[1]
Ludwig von Mises Memorial LectureAustrian Economics Research ConferenceLudwig von Mises InstituteAuburn, AlabamaMarch 22, 2014
It comes as a great honor to have been asked to present the Ludwig von Mises Lecture at the 2014 Austrian Economics Research Conference. One of the first books that I read on economics many years ago was his Theory of Money and Credit ([1924] 1953). Other works that had a great influence on my view of economics were his Human Action (1963), The Free and Prosperous Commonwealth (also known as Liberalism, 1962), Omnipotent Government (1944), and Theory and History (1957).
Although von Mises would disapprove of my mathematical and statistical proclivities, his works contain several insights that I think are very relevant to modern economics and should be better known. Today I would like to discuss four of these Misesian insights that pertain to macroeconomic issues.
The first of these insights is von Mises’s concept of the historical transmission of the value of money. An immediate consequence of this is a model of the mechanism by which prices adjust to a change in the money supply.
A second insight, which ultimately also arises from von Mises’s historical transmission concept, is that of market equilibrium, as contrasted to the fashionable concept of “rational expectations” equilibrium. Although “rational expectations” (or more accurately, “equilibrium expectations”) is a useful exercise for evaluating the internal consistency of policies, it is a completely unrealistic model of how the economy actually works.
The third Misesian insight I wish to discuss is that of heterogeneous, inconvertible capital. This contrasts sharply (and realistically) with the popular homogenous capital assumption of the “neoclassical growth model.”
And finally, the fourth Misesian insight I will discuss is the nature of the liquidity effect, and how it relates the so-called “Taylor Rule” to the Quantity Theory of Money.
- THE HISTORICAL TRANSMISSION OF THE VALUE OF MONEY In the 1924 second edition of The Theory of Money and Credit (trans. 1953), von Mises addressed the criticism that his contemporary Karl Helfferich has raised against using marginal utility theory to explain the level of money prices:
Helfferich is of the opinion that there is an insurmountable obstacle in the way of applying the marginal utility theory to the problem of money; for while the marginal-utility theory attempts to base the exchange value of goods on the degree of their [usefulness] to the individual, the degree of [usefulness] of money to the individual quite obviously depends on its exchange-value, since money can have utility only if it has exchange-value, and the degree of [its usefulness] is determined by the level of the exchange-value. Money is valued subjectively according to the amount of consumable goods that can be obtained in exchange for it, or according to what other goods have to be given in order to obtain the money needed for making payments. The marginal utility of money to any individual, i.e., the marginal utility derivable from the goods that can be obtained with the given quantity of money or that must be surrendered for the required money, presupposes a certain exchange-value of the money; so the latter cannot be derived from the former. ([1924] 1953, pp. 119–120)
In other words, marginal utility theory states that the relative prices are equal to ratios of the corresponding marginal utilities. This works for the relative prices of say good i and good j as follows:
Pi/Pj = MUi/MUj With discretely divisible goods, the Austrian version of utility theory actually admits the possibility of intrinsically ordinal marginal utilities which cannot be manipulated arithmetically. However, they will still place quantifiable bounds on marginal rates of substitution and therefore on prices. In this paper we assume that goods are continuously divisible, which in turn implies that utility is essentially cardinal and that marginal rates of substitution are exactly determined by ratios of (essentially cardinal) marginal utilities. See McCulloch (1977) for further clarification.
However, Helfferich argued that marginal utility theory is circular for the prices of goods in terms of money, since the nominal price of good i should be determined by the ratio of good i’s marginal utility toMU$, î , the marginal utility of money to be spent on goods other than i:
Pi = MUi/MU$, î
Yet MU$, î is determined by Pj , j ≠ i, while these are determined, in part, by Pi itself! Figure 1 below illustrates what I call this “Vicious Circle of Helfferich”:
Figure 1. The Vicious Circle of Helfferich
Von Mises replied to Helfferich’s argument as follows:
Those who have realized the significance of historically transmitted values in the determination of the objective exchange-value of money will not find great difficulty in escaping from this apparently circular argument.... It is true that the subjective valuation of money presupposes an existing objective exchange-value; but the value that has to be presupposed is not the same as the value that has to be explained; what has to be presupposed is yesterday’s exchange-value, and it is quite legitimate to use it in an explanation of that of to-day. The objective exchange-value of money which rules in the market to-day is derived from yesterday’s under the influence of the subjective valuations of the individuals frequenting the market, just as yesterday’s in its turn was derived under the influence of subjective valuations from the objective exchange value possessed by the money the day before yesterday. (120¬–121)
In other words, von Mises has in effect replaced the “Vicious Circle of Helfferich” with what I call the “Benign Helix of Mises,” illustrated in Figure 2 below. Here, the price of good i at time t, represented byPit , is determined not by Pjt j ≠ i, but by Pjt-λ , where λ is the average lag in price information. This in turn is determined by Pit-2λ , etc.
Figure 2. The Benign Helix of Mises
Von Mises’s concept of the historical transmission of the value of money leads immediately to his theory of the adjustment of prices to an increase in the supply of money:
An increase in a community’s stock of money always means an increase in the amount of money held by a number of economic agents, whether these are the issuers of fiat or credit money or the producers of the substance of which commodity money is made. For these persons, the ratio between the demand for money and the stock of it is altered; they have a relative superfluity of money and a relative shortage of other economic goods. The immediate consequence of both circumstances is that the marginal utility to them of the monetary unit diminishes. This necessarily influences their behavior in the market. They are in a stronger position as buyers. They will now express in the market their demand for the objects they desire more intensively than before; they are able to offer more money for the commodities that they wish to acquire. It will be the obvious result of this that the prices of the goods concerned will rise, and that the objective exchange value of money will fall in comparison. But this rise of prices will by no means be restricted to the market for those goods that are desired by those who originally have the new money at their disposal. In addition, those who have brought these goods to market will have their incomes and their proportionate stocks of money increased and, in their turn, will be in a position to demand more intensively the goods they want, so that these goods will also rise in price. Thus the increase of prices continues, having a diminishing effect, until all commodities, some to a greater and some to a lesser extent, are reached by it ([1924], 1953, p. 139).
In modern terms, von Mises is describing what is known as a partial adjustment mechanism for the price level, with the excess supply of money driving the inflation rate. In McCulloch (1980), I show that under simplifying assumptions, this can be written as
(1) π = γ(log(M/P) - log mD) + πa + ε
Here, π = Ṗ/P is the inflation rate, M is the nominal money supply (appropriately measured), mD is real money demand, πa is anticipated inflation reflecting the fact that agents extrapolate past prices for obvious inflation trends when predicting current and future prices of goods not currently being purchased, and ε is a white noise error term caused by nonmonetary microeconomic shocks. The adjustment coefficient γ = ηm/(λw) depends on η, the elasticity of marginal utility with respect to wealth (also known as the relative rate of risk aversion), real money balances m, real wealth w, and the average lag in price information λ.
In McCulloch (1980), I call this Mises-inspired equation “the Moderate Quantity Theory of Money.” According to what I call the “Extreme Quantity Theory of Money,” prices adjust instantaneously to changes in the money stock, so that inflation simply equals concurrent money growth, net of real income growth, and plus velocity growth and white noise micro shocks. According to the “Moderate Quantity Theory,” however, inflation does not respond at all to concurrent money growth. In fact, if money supply equals money demand, inflation will be driven entirely by inflationary expectations plus micro noise. However, if these non-monetary factors drive prices away from their Quantity Theory equilibrium level, the first term will eventually begin to pull prices back toward their equilibrium level. The long run average inflation rate will therefore ultimately reflect the long run average money growth rate.
This “Moderate Quantity Theory” is a great improvement over the famous “real adjustment” equation of Cagan (1956), which was used by Chow (1966), Goldfeld (1973), and others to estimate the demand for money. According to the real adjustment equation, the rate of change of real money balances is proportionate to the gap between real money demand and real money balances. This turns out to be equivalent to (1), but with the expected inflation term replaced by the rate of money growth. So long as the money supply is constant, this will behave like a price adjustment equation in response to any changes in money demand or microeconomic shocks. However, it unrealistically predicts that the price level will perfectly track any changes in the money supply, just as does the Extreme Quantity Theory.This insight is due to my Boston College colleague Harold Peterson.
The “P-star” model of Hallman, Porter and Small (1991) comes very close to the Mises-inspired equation (1). The only difference is that they did not provide micro foundations for their equation, and that they replace anticipated inflation by several lags of actual inflation. In practice it may be that a distributed lag of past inflation is the best available proxy for inflationary expectations, but it is better to make the inflationary expectations explicit, and only then to consider how best to proxy them empirically.Hallman et al. define their P* in terms of the M2 monetary aggregate, though this is not an essential part of their adjustment mechanism. The “nominal adjustment” equation of Goldfeld (1976) makes sense for a small open economy with a fixed exchange rate and an endogenous money supply determined by the specie flow mechanism. However, it makes little sense when the money supply is exogenous or determined by seigniorage considerations. Carr and Darby (1978) propose an equation like (1), but with expected inflation replaced by expected money growth. This term would only make sense in an “Extreme Quantity Theory” context in which inflation was driven contemporaneously by money growth.
- MARKET EQUILIBRIUM VERSUS “RATIONAL EXPECTATIONS” EQUILIBRIUM Von Mises’s theory of the historical transmission of the value of money leads directly to his concept of a Market Equilibrium, in which prices convey sufficient information about other agents’ tastes and endowments that agents’ actions are efficiently coordinated, without central planning or indeed any actual knowledge of other agents’ information. In an “evenly rotating economy” in which tastes and endowments are constant, the market will actually find the Walrasian equilibrium, without the help of a “Walrasian auctioneer” who calls out hypothetical price vectors. If tastes and endowments change over time but with a considerable element of continuity, the market will never perfectly reach the Walrasian equilibrium, but at least will be continually moving in its direction.
This theory of Market Equilibrium stands in sharp contrast to the fashionable “Rational Expectations Equilibrium” concept first proposed by Muth (1961), and elaborated on by Robert Lucas, Thomas Sargent, Neil Wallace, and others. According to this model, every agent knows the tastes, endowments, and production possibilities of every other agent, along with the intentions of policy makers, and then computes the equilibrium of the economy, to within random shocks not known to anyone.
As was pointed out by the Austrian economist Fritz Machlup, in an unpublished note written shortly before his death, the term “Rational Expectations” is an abuse of terminology, since “rational” simply means using one’s own information in a logical manner, and does not imply knowledge of other agents’ information, let alone the computationally impossible task of coordinating all this information.
“Equilibrium Expectations” would be a far more appropriate, and far less misleading, term for what Muth called “Rational Expectations.” As such, “Equilibrium Expectations” is a very useful exercise for evaluating the long-run implications of policies such as inflationary finance or monetary stimulation through the Phillips Curve, even if it is an entirely unrealistic model of how the economy actually works.
Proponents of “Rational Expectations” often make the fallacious argument that if economists believe that agents are rational, then they must accept that agents’ expectations are “Rational.” This is the logical fallacy of assigning one term two definitions, and then equating the two definitions. Some even accuse those who deny this equation of irrationality on their own part.
Today, even some of the early proponents of “Rational Expectations” are admitting that it imposes unrealistic informational assumptions on agents, and now instead propose what they call “Bounded Rationality” (e.g. Sargent, 1993). But this itself is yet another misleading misnomer: If a person is only 30 percent rational, then that person is 70 percent mentally incompetent. But if a person is only 30 percent omniscient, then he or she is 70 percent human. “Bounded Omniscience” would therefore be a better term for what these economists really have in mind than “Bounded Rationality.”
- HETEROGENEOUS, INCONVERTIBLE CAPITAL Mainstream macroeconomics typically treats “capital” as a homogeneous good whose structure, if any, is only relevant for microeconomic questions. Thus, the popular “neoclassical growth model” typically contains an equation according to which consumption plus investment equals output net of depreciation:
C + ΔK = f(K,L) - δK
The Austrian economists Ludwig von Mises and F.A. Hayek instead stressed that capital (“the produced means of production” as Böhm-Bawerk put it) is to a great extent specific to the intended ultimate product, and thus is both heterogenous and inconvertible. In their “Austrian” theory of the business cycle, they emphasized that goods available at different points in time are economically different goods. Following Böhm-Bawerk, the “more roundabout means of production” are generally more productive, in part because they permit the use of technologies that involve types of capital that would not have time to be constructed for less roundabout production plans. The inconvertibility of this horizon-specific capital plays a central role in the Austrian business cycle theory.
Von Mises himself made no attempt to quantify this concept, either mathematically or graphically. In his Pure Theory of Capital, Hayek (1975) attempted to illustrate it graphically, but as he confined himself to unrealistically simplistic technologies, he was not very successful.
In fact, this Misesian concept is easily illustrated in terms of the “Production Possiblity Frontier” (PPF) of the early marginalist F.Y. Edgeworth. This tool was adapted to intertemporal production by Irving Fisher in his very Böhm-Bawerkian Theory of Interest (1930).Fisher in fact dedicated his 1930 book to Böhm-Bawerk and to Böhm-Bawerk’s precursor John Rae.
Figure 3 below shows a typical PPF for the case of two outputs, X and Y. Points A and B on the PPF represent two output combinations that are feasible given the available inputs. In the elementary exposition of this PPF, there are two inputs, homogeneous capital K and labor L, and two concave, constant returns to scale production functions with differing factor intensities. The resulting PPF bends away from the origin as illustrated.The Austro-Hungarian mathematician John von Neumann provided a very Menger-like proof of both diminishing marginal products and of the general convexity of the production possibility set for a very general constrained technology, as discussed in Gale (1960). In each stage of production, there is a nonnegative vector x of inputs, a nonnegative vector y of production activities, and a vector z of outputs. Activities are constrained by the vector inequality Ay ≤ x, where A is a matrix of nonnegative input requirements, while outputs one period later are given by x = By, where B is a matrix of nonnegative output coefficients. The Production Possibilities Set is then convex. Its PPF is piecewise linear in the case of two outputs, but in a complex economy with a vast number of inputs and activities, will be nearly smooth as in the illustrations. Two inputs are complements in Menger’s sense when they are both required by a single activity. Two inputs are substitutes when they are required by different activities that produce the same output. Complements tend to increase one another’s marginal product, while substitutes tend to decrease the other’s marginal product, so that two inputs may be said to be net complements or net substitutes depending on their net effect on one another’s marginal product. Outputs are joint if they are produced by the same activity or activities. This very Mengerian von Neumann model is differentiated from the oversimplified Input/Output model of Leontief by the separation of outputs from inputs and the passage of time. In the Leontief I/O model, for example, a chicken could be used to lay the very egg from which it itself hatches, while this is impossible in the von Neumann model. I have no direct knowledge that von Neumann was inspired by Menger, but it seems very likely that he was.
Figure 3. A Production Possibility Frontier (PPF) with Two Outputs, X and Y
But suppose now that instead of being pre-existing and homogeneous, capital must be produced, and that the types of capital tools and equipment that one would ideally use to produce X are different from those that would be used to produce Y. Production now has at least two stages and involve three points in time: At time t=1, the initial endowment of resources is used to produce specialized tools and equipment that will become available at time t=2. Then at time t=2, these produced means of production are combined with non-produced factors like land and labor to produce X and/or Y at time t=3.
The t=1 PPF over X and Y will still be convex as in Figure 3, but now the t=2 PPF will depend on which combination of X and Y was targeted back at t=1. If point A was targeted at t=1, A will still be feasible at t=2. However, point A will be the only point on the original PPF that is still feasible. Elsewhere, the new t=2 PPF will lie strictly inside the original PPF, as illustrated by the red curve in Figure 3. In particular, point B will no longer be attainable. On the other hand, if point B was targeted back at t=1, only B will still be attainable at t=2, as illustrated by the blue curve in figure 3. In mathematical terms, the elasticity of transformation of the PPF declines as time passes and production is committed to a particular point on the original PPF. (The elasticity of transformation is the negative of the elasticity of substitution, defined along a PPF instead of an isoquant or indifference curve.)
Figure 4.
The situation illustrated in Figures 3 and 4 is basically a microeconomic problem, and not a macroeconomic one: If at t=1 one builds umbrella factories instead of sunscreen factories, but at t=2 if it is realized that the demand will be for sunscreen instead of umbrellas, one will have lost the capability to produce as much sunscreen as would have been feasible ex ante. However, there is not too much or too little demand for goods as a whole, just too much or too little demand for umbrellas versus sunscreen.
In an intertemporal context, however, it is possible to have too much or too little demand for present goods as a whole relative to future goods, their relative price being governed by the real interest rate. In order for malinvestment to be an issue, there must have been a third, earlier period when horizon-specific capital investments were made. Figure 5 below illustrates a general PPF for aggregate consumption possibilities C1,C2, and C3 in a world with three periods t1, t2, and t3. At time t1, producers will target an output stream like point A that maximizes the present discounted value of future output, given the real interest rates that are then current.
Figure 5. A Three-Period Intertemporal PPF
During the second period t2, the chosen value of C1 will have already been produced and consumed, so that it can no longer be changed. Figure 6 below shows the section through Figure 5 corresponding to the C1 value of point A. Figure 7 shows this section by itself without the C1 axis.
Figure 6. Time t1 PPF with Section at Level of C1 Corresponding to Point A
Figure 7. Section of t1 PPF Shown in Figure 6, Without C1 Axis
Although any point on the t1 PPF section shown in Figure 7 could have been produced if one had begun back in t1, by t2 it is too late to produce any point on it but A. It is not necessary to follow through with A itself, but any other combination of C2 and C3 will be inside the original PPF, as shown in Figure 8 below.
Figure 8. The “Austrian Capital Effect”
This “Austrian Capital Effect” was first illustrated in this manner in my 1981 article, “Misintermediation and Macroeconomic Fluctuations.” This diagram shows how intertemporal malinvestment imposes real costs on the economy. The problem is not overinvestment or underinvestment per se, since the level of C1 is not necessarily incorrect. Rather it is that producers have invested in the wrong structure of capital, given consumers’ preferences over C2 and C3.Guo and McCulloch (2013) illustrate the Austrian capital effect with a simple agricultural economy that can choose between using labor to plant crops immediately or to build plows that will increase future productivity but delay consumption.
It should be noted that the interest rate that most directly affects the t1 choice of C2 relative to C3 is the tj forward interest rate linking these two points in time, and not the t1 general level of interest rates per se. Unfortunately, Mises and Hayek did not take the term structure of interest rates into account, as is required to make this nuanced point.
- THE LIQUIDITY EFFECT A popular misconception in the mainstream macroeconomic literature is that the “Liquidity Effect” of a monetary expansion is the reduction in real and nominal interest rates required to induce agents to holdthe new money, given the received price level and a real money demand function that has some interest-elasticity.
In fact, Mises would be the first to point out that the immediate effect of an injection of money through the banking system is the reduction in real (and therefore nominal) interest rates required to induce agents to borrow the new money from the banks with the primary intention of spending it, on consumption or investment. As Mises pointed out above, a disequilibrium excess supply of money will persist for some time after the monetary injection, and hence the disequilibrium liquidity effect will persist for the same length of time.
This correspondence between the excess supply of money and the disequilibrium liquidity effect can help us understand how the “Taylor Rule” can, at least in principle, be used to regulate inflation in a fiat money economy like the United States since 1968: If the central bank knows the demand for real money balances, it can use the nominal money supply and the Quantity Theory of Money to regulate the price level and hence inflation. On the other hand, if it knows the equilibrium real interest rate but has no trust in the stability of the money demand function, it can, in principle, still regulate the excess supply of money and hence inflation by manipulating interest rates along the lines of the “Taylor Rule.”
CONCLUSION Ludwig von Mises’s writings contain many insights that are very relevant for mainstream macroeconomics. These insights can and should be accepted even by those economists who do not share Mises’s strong policy recommendations on the inevitable counter-productivity of intervention, the gold standard, and the precise nature of the business cycle.
At the same time, Austrian economists should strive to integrate these insights into mainstream economics, rather than isolating themselves from it.
REFERENCESBöhm-Bawerk, Eugen von. 1959. Capital and Interest. South Holland, Ill., Libertarian Press.
Cagan, Phillip. 1956. “The Monetary Dynamics of Hyperinflation.” In Milton Friedman, ed., Studies in the Quantity Theory of Money. Chicago: University of Chicago Press.
Carr, Jack, and Michael R. Darby. 1978. “The Role of Money Supply Shocks in the Short-Run Demand for Money.” UCLA Discussion Paper No. 9B.
Chow, Gregory C. 1966. “On the Long-Run and Short-Run Demand for Money,” Journal of Political Economy 74: 111-31.
Gale, David. 1960. The Theory of Linear Economic Models. New York: McGraw-Hill.
Goldfeld, Stephen M. 1973. “The Demand for Money Revisited,” Brookings Papers on Economic Activity 3: 577–645.
——. 1976. “The Case of the Missing Money,” Brookings Papers on Economic Activity 6: 683–739.
Guo, Kevin, and J. Huston McCulloch. 2013. “Heterogeneous Capital and Misintermediation.” Central University of Finance and Economics, Beijing.
Hallman, Jeffrey, Richard D. Porter, and David H. Small. 1991. “Is the Price Level Tied to the M2 Monetary Aggregate in the Long Run?” American Economic Review 81: 841–858.
Hayek, Friedrich A. von. 1975. The Pure Theory of Capital. Chicago: University of Chicago Press.
McCulloch, J. Huston. 1977. “The Austrian Theory of the Marginal Use and of Ordinal Marginal Utility,” Zeitschrift für Nationalökonomie 37: 249–280.
——. 1980. “The Microfoundations of the Moderate Quantity Theory,” Ohio State University. Available at www.econ.ohio-state.edu/jhm/papers/MQT80.pdf.
——. 1981. “Misintermediation and Macroeconomic Fluctuations,” Journal of Monetary Economics 8: 103–115.
Mises, Ludwig von. 1960. Epistemological Problems in Economics. Trans. George Reisman. Reprinted by Ludwig von Mises Institute. Available at www.mises.org/epofe.asp.
——. 1962. The Free and Prosperous Commonwealth: An Exposition of the Ideas of Classical Liberalism. Princeton: Van Nostrand.
——. 1963. Human Action: A Treatise on Economics, 2nd ed. New Haven: Yale University Press.
——. 1944. Omnipotent Govenment: The Rise of the Total State and Total War. New Haven: Yale University Press.
——. 1957. Theory and History: An Interpretation of Social and Economic Evolution. New Haven: Yale University Press.
——. 1953. The Theory of Money and Credit, new enlarged edition. New Haven: Yale University Press, 1953. Parts 1–3 trans. H.E. Batson from the 1924 2nd. German edition. First German edition, 1912.
Muth, John. 1961. “Rational Expectations and the Theory of Price Movements,” Econometrica 29: 315–335.
Sargent, Thomas. 1993. Bounded Rationality in Economics. Clarendon Paperback.
Volume 3, No. 2 (Summer 2000)The book brings together sources that to some Austrians may appear hardly compatible, if not inconsistent. Insiders know that there are some significant differences between the views of, say, Mises, Hayek, and Lachman,even with respect to method and methodology. However, the book integrates these different Austrian sources into a relatively coherent picture. The fact that the authors do not want to enter in any depth into issues presently underdebate within the “Austrian” School itself may be explained by the fact that they intend to address their book to the economics profession at large rather than to the inner circle of convinced Austrians. The drawback of this strategy is that the reader will not find in the book answers relating to questions that have been intensely debated recently within Austrian economics itself.
Volume 4, No. 1 (Spring 2001)Wagner charges the Austrian business cycle with “obsolescence,” and describes it as “incoherent.” What is the reason for this denunciation? It is obsolete. It cannot be denied that institutions have changed during these seven decades, but to think that this would call for an alteration of a praxeological theory is surely mistaken. No one denies that alternative ways of doing things may or may not make praxeological theories irrelevant, in the sense of not being applicable. But Wagner, in urging his “chaff” thesis, is clearly going beyond these parameters. It is time to bring this discussion to a close. Wagner set out to separate the Austrian wheat from the Austrian chaff, in an attempt to retain the former and jettison the latter. It is difficult to see in what way he has succeeded.
Volume 17, no. 2 (Summer 2014)Book ReviewThe Federal Reserve and the Financial CrisisBen S. BernankePrinceton and Oxford: Princeton University Press, 2013, 134 pgs.
Ben Bernanke, then chairman of the Federal Reserve System, gave a series of lectures to students at George Washington University in 2012. At the time, the American economy was amidst its weakest recovery of the post-war period and the Fed was widely heralded as having averted a second Great Depression. Bernanke’s lectures focused on 1) the origin and role of the Fed, 2) its performance in the post-War era (conveniently excluding the Great Depression), 3) its policies and performance in the lead up and as a response to the credit crunch of 2008, and finally 4) a review of its post-crisis performance.
There is trouble lurking in each of the book’s four chapters. The text gets off on a wrong foot as Bernanke overviews the origins and purposes of the Fed. By Bernanke’s reckoning, any central bank is created to achieve stability in the economy (i.e., through low and stable inflation and by avoiding economic swings), and in the financial system, by preventing financial panics and freezes.
Where do such instabilities come from? Bernanke nonchalantly attributes instability to the fact that “no bank holds cash equal to its deposits” (p. 7). He does not refer to the possibility that fractional reserves could breed broader instabilities, and in a bid to underscore his point Bernanke notes that under the National Banking System (1873–1914), banks did indeed regularly close their doors during crises and panics. Recent research suggests that even though banking was not especially stabilizing during this period, hamstrung as it was by many onerous regulations, the Federal Reserve has fared far worse in terms of both monetary and macroeconomic instability (Selgin, White, and Lastrapes, 2012).
Not referencing the imperfections of the period prior to the Fed is not too surprising given the sad state of historical knowledge amongst economists. More serious is Bernanke’s treatment of the Great Depression, partly because his research of the period is what he was best known for prior to becoming Fed chairman, and partly because it is so misguided. In the lead up to the crash of 1929, Bernanke lists nearly every fault possible in the global economy except a loose monetary policy: an overhang from the World War I, nondescript “problems” with the gold standard, a financial bubble and contagion all figure prominently as causes of the downturn (pp. 19–20). Recovery did not start until Roosevelt abandoned the gold standard in 1933, and deposit insurance was established in 1934. Similar to most mainstream discussions of the Great Depression, there is little attention paid on the pre-1929 period, nor is the thesis entertained that the financial boom of the late 1920s was indicative of a lax monetary policy, and a sign that deeper imbalances were being bred in the real economy. The analysis is quite limited in comparison to, e.g., Rothbard (1963).
Reading the chapters dealing with the Fed’s more recent performance is the most frustrating part of the book. Bernanke fills nearly 100 pages with reasons for the credit crunch of 2008; only once does he concede that the Fed contributed to the instability leading up to the crisis, or the severity of the crash.
”Psychology” played a big role in the increase in housing prices (p. 42). Reduced lending standards and the proliferation of nonprime loans allowed first-time buyers to enter the market who would have been better off sitting on the sidelines (pp. 43–44). (He later [p. 113] mentions that credit scores on newly originated mortgages were not lower during the housing boom, but does not explain how this squares with the claim that lenders blindly pursued nonprime borrowers.) Credit rating agencies were either wrong in their risk assessments or manipulated to understate default risks (pp. 69–70). Insurers developed and sold complex derivatives that bred instabilities (p. 70). There was a lack of regulation and oversight (pp. 50–51). Only with this last point does Bernanke concede that the Fed did not perform this role as well as it could have and may have contributed to the crisis as a result. But its failure in this regard was, according to him, endemic under the former Fed Chair, Alan Greenspan, and not a failing during his tenure at the Fed, going so far as to state that “when I became chairman, we did undertake some of these protections but it was too late to avoid the crisis” (p. 50). One gets the impression that Bernanke thinks that if only he assumed the role a little sooner, a lot of pain could have been avoided.
Bernanke spills much ink explaining research (from inside the Fed or predominately written in association with the Federal Reserve) that absolves the Fed of responsibility in causing housing prices to become unhinged from fundamentals (pp. 52–54). This is not surprising coming from the Fed’s chairman. What is surprising is that he spends almost as much time noting that the Fed’s role in the housing crisis is hotly disputed and that “this question [about the relationship between monetary policy and housing prices] continues to be debated” (p. 54, fn. 4). On the one hand, Bernanke goes out of his way so many times to comment on the controversial nature of monetary policy having no effect on housing prices that one doubts his sincerity in making the claim. On the other hand, after the crisis the Fed pursued monetary policies explicitly aimed at supporting asset prices, so there can be little doubt that inside the Fed there is a belief that the institution does affect certain assets, including housing.
As in many books, what is not written is as telling as that which is. “Moral hazard” is not mentioned once. Bernanke does mention “too big to fail,” but not in depth or in the context of the Fed promoting the problem (p. 86). Only when pressed by a student during question period does Bernanke follow up on the idea, but only to offer that the Fed’s understanding of the problem is “evolving” and more time is needed to sort out how large a role it played in the crisis (p. 94–95). He does not mention the prospect of unwinding the Fed’s positions until pressed by another student (p. 123), and just reiterates the standard line about reversing the positions through the standard means without giving any attention to the difficulties that will arise if its assets lose value or if the banking sector does not demand them back. It seems to this reviewer that exiting the most expansive monetary policy of the Fed’s history is as important to its success as enacting it. I would have liked to see Bernanke voluntarily bring up the point and expand on it further.
Despite its shortcomings, there is one benefit to this book. Because of its student audience, Bernanke explains clearly what his thoughts are about the role of the Fed leading up to and during the crisis. However misplaced and incomplete his thoughts may be, the clarity of delivery gives merit to an otherwise lackluster book.
Volume 10, No. 4 (2007)
At the beginning of World War I, the US Treasury secretary closed the New York Stock Exchange to stop the sale of dollar-denominated securities. Then, as chairman of the Federal Reserve Board he embraced the "Too Big to Fail" doctrine orchestrating a bailout of New York banks by flooding the nation with paper currency. This pragmatic future Senator was also a major beneficiary of one of the greatest banking enterprises in America.
Volume 15, No. 3 (Fall 2012)
This volume brings together highly important and relevant essays from distinguished authors, all of which are firmly anchored in the tradition of the Austrian School of Economics. The authors not only explain theoretically the causes of the current European economic and political crisis, but also point out, on the basis of sound economic theory and illustrative empirical data, what has to be changed economically and politically to get Europe off the road of capital consumption, impoverishment and misery and return it back on track for freedom and prosperity. What is more, to put forward the correct diagnosis of the root cause of the European crisis is indispensable because most of the bitter consequences of today’s interventionism will only show up at some point in the future—and this will make it all the more difficult for the superficial observer and layman to discern their true origin. The detailed explanations of the European policy failures analyzed in this book must therefore be seen as intellectually powerful contributions to help redirecting the European project to what most people presumably expect it to achieve: freedom and prosperity.
Volume 8, No. 1 (Spring 2005)The skyscraper index, created by economist Andrew Lawrence shows a correlation between the construction of the world’s tallest building and the business cycle. Is this just a coincidence, or perhaps do skyscrapers cause business cycles? A theoretical foundation of “Cantillon effects” for the skyscraper index is provided here showing how the basic components of skyscraper construction such as technology are related to key theoretical concepts in economics such as the structure of production. The findings, empirical and theoretical, suggest that the business cycle theory of the Austrian School of economics has much to contribute to our understanding of business cycles, particularly severe ones.
Volume 8, No. 1 (Spring 2005)That Hayek’s work on money, investment, and business cycle theory should be misunderstood and misrepresented poses nothing new. Its contemporaneous failure to win approval might be attributed to Hayek having “purposely refrained from combining purely theoretical considerations with discussions of current events” (Hayek 1933, p. 18). Further explanation might lie in a methodology in which theory, founded upon introspection, takes precedence over empirical work.
Volume 7, No. 3 (Fall 2004)Markets are not efficient as that term is currently used in academic finance. Rather, markets are reflexive in that market behavior and the fundamentals reflect each other via a two-way, interactive feedback loop. Free markets remain reflexive unless market participants close the feedback loop, which they can do, and have done, to justify and perpetuate a boom. Practical finance theory was clear on the market behavior boom-bust cycles generate, but it was silent regarding the cause of such cycles. Austrian business cycle theory, on the other hand, provides a clear theoretical explanation of the cause and effects of business cycles. By utilizing both theories in a unified manner it is possible to track each stage of a business cycle, which was demonstrated in an analysis of the recent new economy business cycle. Such an approach could be enormously beneficial to both academicians and practitioners during the next business cycle.
Volume 9, No. 1 (Spring 2006)Scholars of Austrian economics argue persuasively that formal models are not able to capture the complex dynamics of market processes. In the eyes of Austrian economists the market is not only an abstract place of exchange between buyers and sellers of goods, but also a process that helps to generate knowledge by letting economic agents reveal their preferences in voluntary exchanges.
Volume 9, No. 2 (Summer 2006)ABC theory is founded on the concept of a sustainable, market-determined interest rate, and predicts negative consequences when that equilibrium is persistently disturbed. Economists and laypeople are well aware of these consequences: the periodic high unemployment associated with the business cycle. The policy prescriptions of the Austrian School are unmistakable: first, never disturb the interest rate with credit expansion or monetary inflation, and second, after the first policy prescription has been violated, never interfere with entrepreneurial planners’ efforts to liquidate suboptimal production plans as rapidly as possible. As long as economists and policy makers believe the business cycle can be avoided through the activism of charismatic central bankers, recessions will be inevitable.
Mainstream macroeconomists may—and do—disagree with such an assessment, but Austrian macroeconomists rightly consider the Misesian/HayekianThe author recognizes that, at least in terms of emphasis if nothing else, there exist some differences between these two theorists’ treatments of cycles. Nevertheless, the purpose of this essay lies elsewhere, so herein rather little will be made of those differences. theory of the business cycle to be one of the signal achievements of the entire Austrian School of thought. This Austrian business cycle theory (ABCT) offers a unique perspective on the destructive array of private sector incentives created by central bank manipulations of the supplies of money and credit
ABCT is essentially a theory of unsustainable economic expansions, that is, macroeconomic expansions that must unavoidably be followed at some point by macroeconomic contractions. At the center of this scenario is the phenomenon of malinvestment. Thus, in order to explain ABCT one must be able to convey in what malinvestment consists. In the past, Austrians have usually done this either entirely by means of verbal explication or with the assistance of certain unconventional constructions such as Hayekian triangles.Recently, Roger Garrison has expanded this approach by also employing a modified version of the conventional production possibilities frontier (2001, pp. 59–83). This very helpful technique sets investment versus consumption as the alternative production choices, along with the further distinction between sustainable and unsustainable boundaries. These figures relate the stages of production to the magnitude of ultimate output and thus can reveal the effects of a change in market interest rates on the structure of production. However, to grasp the significance of such triangles one must also comprehend certain distinctively Austrian ideas such as“roundabout production” and the average production period. Students of economics who are not already familiar with the Austrian School are thus not likely to find Hayekian triangles to be very enlightening. Something more familiar to such students might prove more helpful.
Pursuing that line of thought, the present paper will offer an interpretation of malinvestment in more conventional terms, using such frameworks as the familiar capital asset pricing model (CAPM) seen so often in finance classes. In addition, the everyday observation about the disproportionate effects of interest rate changes on the present values of assets with different maturities will be shown to be congruent with Hayekian triangles, thus removing the latter from the realm of the exotic. Finally, the important role of the “subsistence fund” in understanding malinvestment will be illustrated. First of all, however, the basics of ABCT will be briefly reviewed
ABCT in a Nutshell The distinctive Austrian approach to business cycles is bundled within the two “universals” of macroeconomics, time and moneyIn financial terms, could one say that the parallel universals are risk and return? (Garrison 2001, pp. 47–52). Production in a modern economy is a roundabout process. It takes time and is measured in monetary units. The intertemporal dimension of the structure of production is, and I believe quite rightly, untiringly emphasized by Austrians. They always distinguish higher-order capital goods, which function at or near the beginning of the temporal string, from lower-order consumer goods, which are the culmination of the process. The complicated and somewhat fragile production structure requires that complementary inputs be available not only in the right magnitudes but also at the right moments in time. If they are not, then projects that appeared profitable are soon revealed to be unprofitable. In other words, what appeared to be capital creation is seen in fact to be capital consumption. ABCT focuses on the “medium run,” because that is where problems arise. In the short run, the capital structure cannot be changed significantly, and in the long run all errors have been rectified. It is in the medium run that there is time enough for capital projects to be initiated and the direction of production to change, but insufficient time for any possible malinvestments to be corrected—at least not without serious repercussions. This inability to smoothly liquidate or redirect projects stems largely from the heterogeneity of most capital goods.
What is the source of the widespread “cluster of entrepreneurial errors” (Rothbard 1970, p. 746; 1975, pp. 18–21) that typifies the boom-bust sequence? It is that market rates of interest are driven below the “natural rate” as result of credit expansion by the central bank. Market rates are the result of the supply of and demand for credit (or loanable funds), while the natural rate is an expression of individuals’ time preferences, that is, their preferred rate of substitution between present goods and future goods. Such declines in market rates make it appear as if consumers have chosen to save (delay consumption) at a higher rate than before, when in fact they have not done so. Furthermore, the increased credit available at relatively low interest rates must appear as an increase in funding for businesses. Otherwise, no cycle will appear (Rothbard 1978, pp. 152–53).
The low rate of interest and abundant credit induce businesspeople to lengthen the production process.Critics of ABCT have challenged the plausibility of pervasive business “errors” of this sort. Carilli and Dempster (2001) have provided an intriguing game-theoretic rebuttal to such a challenge. This occurs because the net present value of longer-term projects rises relative to that of shorter-term projects (see figure 1). Entrepreneurial demand for capital goods thus increases, and producer goods’ prices rise relative to consumer goods’ prices. The result is a production structure that is unsustainable. Consumers will eventually reassert their unchanged time preferences via strong demand for consumer goods, and the prices of consumer goods begin to rise relative to those for capital goods. The resources needed to complete the projects will not be forthcoming, so many such projects cannot be completed at all, or can be completed but at a loss. The economy is being pulled in two directions. Entrepreneurs want more capital goods (and the complements to those capital goods), at the same time that consumers want more consumer goods. The needed correction comes in the form of a recession, during which many projects are liquidated and unemployment rises. Macroeconomic equilibrium can only be re-established when and if the central bank ceases to expand the supply of credit, thus allowing market rates of interest to once again be consistent with time preferences.
Figure 1
The Subsistence Fund Regardless of which aspect of the credit expansion one highlights, whether it is the pattern of market interest rates that first encourages, then discourages, greater roundaboutness, the zero-sum struggle for available resources between lower-order goods and higher-order goods, the overinvestment which prolongs the contractionary, corrective phase of the cycle, the scarcity of resources that serve as complements to the lengthened capital structure, or the “forced savings” imposed on consumers by entrepreneurial malinvestment, one theme (implicitly) runs through the entire exposition of the Austrian theory of unsustainable business cycles: the subsistence fund. It is, in fact, a concept that links all aspects of the theory. Moreover, since it focuses on the actions of the capitalist/entrepreneur as the key appraising agent, it pinpoints a crucial element of ABCT, i.e., the proposition that unsustainable expansions only occur if and when it is businesspeople to whom the artificial increase in credit is made available.
[T]he Austrian theory of the trade cycle reveals that only the inflationary bank credit expansion that enters the market through new business loans (or through purchase of business bonds) generates the overinvestment in higher-order capital goods that leads to the boom-bust cycle. Inflationary bank credit that enters the market through financing government deficits does not generate the business cycle; for, instead of causing overinvestment in higher-order capital goods, it simply reallocates resources from the private to the public sector, and also tends to drive up prices. Thus, Mises distinguished between “simple inflation,” in which the banks create more deposits through purchase of government bonds, and genuine “credit expansion,” which enters the business loan market and generates the business cycle. . . . Mises did not deal with the relatively new post-World War II phenomenon of large-scale bank loans to consumers, but these too cannot be said to generate a business cycle . . . because they will not result in “over” investment, which must be liquidated in a recession. Not enough investments will be made, but at least there will be no flood of investments which will later have to be liquidated. Hence, the effects of diverting consumption [/] investment proportions away from consumer time preferences will be asymmetrical, with the overinvestment-business cycle effects only resulting from inflationary bank loans to business. (Rothbard 1978, pp. 152–53)
By what standard is a credit expansion deemed to be cycle-generating? First of all, it must be an “artificial” expansion, that is, not the result of a decline in the rate of time preference. This is the necessary but not sufficient condition. A further stipulation is needed: the gap between credit and saving must be experienced by businesses, not consumers. Entrepreneurs must have access to credit in excess of the saving that is available to them. That is the fundamental message which Rothbard conveys quite emphatically in the citation above. Some Austrians may speak and write about a contrast between generic “saving” and the supply of fiduciary credit, but that is insufficiently precise. As Rothbard recognized so clearly, the only discrepancy that really matters insofar as business cycles are concerned is that between the magnitude of saving at the disposal of entrepreneurs and the magnitude of credit at the disposal of entrepreneurs. The former sets the limit on a sustainable lengthening of the capital structure, and the latter identifies the maximum initial investment in capital projects (see figure 2).
Figure 2
It is not saving per se that is the benchmark, but the magnitude of the subsistence fund. What, exactly, is this subsistence fund?
Saving and Productive Expenditure The labor expended by employees of business firms is not, contrary to widespread assumption, the primary or original source of income. One of the serious flaws of classical economics was just that erroneous assumption.It is likely that this error, plus the absence of marginal analysis, has caused some Austrians to pay rather little attention to classical economics. Reflect on a pre-capitalist, primitive world in which there are no businesses, but of course there does exist both labor and land. When goods are produced, what should the income receipts be called? They cannot be wages, because there are no employers to pay wages. They are, unavoidably, profits. In such a world, laborers sell goods but not their own labor. “Smith and Marx are wrong. Wages are not the primary form of income in production. Profits are” (Reisman 1996, p. 479). What occurs as capitalists appear? The proportion of total income that is profit (100 percent in the primitive state) declines as those capitalists provide funds to their employees (wages) in advance of the sale of the finished goods.Here “profit is taken in the accounting sense, rather than the economic sense of the term. That is, the imputed values of the resources possessed by the capitalist are not subtractedfrom his gross receipts. And Since, initially, he makes no payments to the owners of resources, his “explicit costs” are zero. Thus, in the primitive state, all income is profit. This transfers most of the risk from the workers to the capitalists, but it also allows the capitalists to benefit from the increased productivity of the more roundabout production processes.
What then is the source of wages? It is capitalists and their decision to save a portion of their earned income. Placed in the hands of businesspeople, this saving becomes productive expenditure which is used to acquire the factors of production. The greater the amount saved, the more that is available to be spent for labor and other inputs. The wages fund, or subsistence fund,Subsistence fund is really the more accurate term, since businesspeople must compensate the suppliers of any and all inputs, not just the suppliers of labor. is that part of the monetary income of capitalists which is saved and invested in productive projects. Equivalently, it is that portion of the funds which capitalists make available to entrepreneurs that is then used to purchase inputs.It must be noted at this point that there is one category of laborers whose wage incomes do not depend on prior saving by capitalists, namely labor which is not used as a means to the end of generating revenues for businesses. The best examples are domestic servants and government employees (Reisman 1996, p. 695). It overlaps, but is not identical to, the concept of saving.
Some economists will reject the concept of the subsistence fund on the grounds that firm revenues depend on sales to consumers and therefore, in effect, consumers provide the funds that businesses need to hire labor and other inputs. Such a train of thought may seem reasonable, but it flies in the face of another classical insight. John Stuart Mill realized that there was a “fundamental theorem” regarding capital which was often misunderstood even in his day. It appears to be almost wholly forgotten today.
What supports and employs productive labour, is the capital expended in setting it to work, and not the demand of purchasers for the produce of the labour when completed. Demand for commodities is not demand for labour. The demand for commodities determines in what particular branch of production the labour and capital shall be employed; it determines the direction of the labour; but not the more or less of the labour itself, or of the maintenance or payment of the labour. These depend on the amount of the capital, or other funds directly devoted to the sustenance and remuneration of labour. (Mill 1987, p. 79; emphasis in original)
One might think of the above in the following terms. From a macroeconomic perspective, the level of saving determines the level of potential total demand for, and thus the potential total employment of, inputs. It sets an upper limit on sustainable production. From a microeconomic perspective, consumer demand for final goods determines the relative demand for inputs, and thus the pattern of employment of those inputs in the production of particular goods and services. At one level, capitalists and entrepreneurs steer the economy. At a different level, consumers (indirectly) steer the economy. Classical economists emphasized the first; while Austrians emphasize the second. One should note carefully that it is not saving per se that is crucial, but the productive expenditures of entrepreneurs, which are made out of the totality of funding available to those entrepreneurs. In a properly functioning, free-market economy, that pool of funds will consist only of real saving, and no unsustainable macroeconomic expansions will result.On the other hand, in a central banking system with fiat currency, the supply of loanable funds is not coextensive with saving. Therefore, the funds at the disposal of businesses can increase while real saving remains constant, or even declines. This latter situation is, of course, a distinctive feature of ABCT.
Austrians are accustomed to thinking in terms of the relative prices of all things including those of inputs, the imputation of values for higher-order, capital goods from the demand for lower-order, consumer goods, and the allocation of inputs based on their discounted marginal value products.See, for example, Rothbard’s presentation of this approach (1970, pp. 387–424), in the course of which he reminds us that “wages are paid out of capital.” Do Austrians need to abandon that approach? Not at all. Allocations of inputs between industries and firms are driven by the discounted marginal productivity of those inputs; while relative prices drive specific output choices. However, consideration of the subsistence fund yields some insights that may be more difficult to achieve if one avoids the use of the concept. First of all, in a central banking system with fiat currency, the link between real saving and the supply of loanable funds is very loose. Therefore, the link between real saving (by both consumers and businesspeople) and the pool of funds available for business investment is equally loose. In such a system, businesses that invest in new projects may not, in fact, be engaging in truly productive expenditures. This will not be evident ex ante, but it will become painfully clear ex post when the investments have to be liquidated. What appeared to be capital creation reveals itself to be capital consumption.
Also, one might recall the two dimensions of erroneous investment that characterize a typical, credit-driven business cycle: malinvestment and overinvestment. Austrians have explained the former very well.However, in one summary of ABCT, Rothbard surprisingly refers only to overinvestment (1978, pp. 152–53). Malinvestment occurs due to misleading relative price signals, and it necessitates a corrective contraction. But what of the overinvestment? That is, why must the contraction persist for a substantial time and, thus, bring about considerable suffering? The answer to that question may become less opaque if one applies the concept of the subsistence fund. Briefly stated, the overinvestment occurs because entrepreneurs are led to believe that the subsistence fund is larger than it actually is.
The pivotal role played by the concept of the subsistence fund is addressed directly, although from a slightly different angle, by George Reisman, a Misesian who sees much in classical economics that he thinks should be of interest to Austrians:
The wages-fund doctrine held that at any given time there is a determinate total expenditure of funds for the payment of wages in the economic system, and that the wages of the employees of business firms are paid by businessmen and capitalists, out of capital, which is the result of saving; not by consumers in the purchase of consumers’ goods. . . . [T]he abandonment of the wages-fund doctrine and with it, classical economics’ perspective on saving and capital, made possible the acceptance of Keynesianism and the policy of inflation, deficits, and ever expanding government spending. (Reisman 1996, p. 474)
The usefulness of the subsistence fund concept also extends to the issue of complementarity. In ABCT the credit expansion that initiates the cyclical sequence leads to a capital structure that cannot be maintained, because
[I]t is relative scarcity of complementary factors which here causes excess capacity and upsets plans. . . . [C]omplementarity is of the essence of all plans, and withdrawal of a factor, or its failure to turn up at the appointed time, will equally endanger the success of the production plans. (Lachmann 1978, p. 107)
Imagine that the absent factor is labor of a particular kind. If it is unavailable, why is it unavailable? Does it not exist? Surely it does exist, for otherwise no one would plan a project that required its participation. Then why is it not forthcoming in the context of a roundabout production process that entrepreneurs have made lengthier?
A lengthier production structure means that the labor must be applied in an earlier stage of the process, farther removed from the final goods. In other words, the time interval between application of the labor and sale of the final product has expanded. This requires, in real terms, that the workers have available a greater stock of consumer goods by means of which they can sustain themselves over this longer time period. Without such goods, no labor will be made available for these lengthier projects, or the labor may be available but only for a period shorter than the duration of the project. In a crucial sense, consumer goods are used to “purchase” the needed factors of production (Strigl 2000, p. 11). And, ceteris paribus, such an enlarged stock of consumer goods can only exist if time preferences have fallen, proportionately
less is consumed by capitalists, and those capitalists have thus provided businesspeople with a larger subsistence fund. Furthermore, multi-period projects are viable only if the required conditions are replicated intertemporally. “Production can only be maintained if each attained subsistence fund is used to support another roundabout method of production” (Strigl 2000, p. 12). A subsistence fund that is adequate only for one time period will lead, in subsequent periods, to capital consumption as the production process is forced to become more “momentary” and less roundabout.
The tension between capital goods expansion and an undiminished demand for consumer goods helps to highlight the value of the subsistence fund in explaining another key issue in ABCT, that is, why overinvestment occurs as well as malinvestment. Some critics, such as John Hicks, have asserted that while an increased money stock and cheap credit can indeed induce an artificial boom that exhibits a capital-goods bias, the excess money balances in consumers’ hands should quickly correct the restructuring of production or even prevent its appearance in the first place. As Garrison notes, “[w]ithout the over-investment, the malinvestment would be as short-lived as Hicks’s critical remarks suggest” (Garrison 2001, p. 81).
Time is the issue at hand. Entrepreneurs have overinvested in long-term projects, overinvested, that is, in higher-order goods far removed from the final goods. The mix of goods is unsustainable, and so too is the level of production (Garrison 2001, p. 74). To the extent that those higher-order goods are durable and specific, the process of correcting the imbalance will require a significant period of time.
The economy “crashes” because unjustified investments in the early stages of production have been undertaken. The economy recovers slowly, and no doubt painfully, from the contraction because the overinvestment in the early stages of production is sure to involve at least some goods that are durable as well as being firm- or even project-specific. Liquidation of such goods, and the firms or projects employing them, will be a difficult and time-consuming process. Re-establishing a sustainable level and mix of goods will take time. Quick and painless adjustments are out of the question. (Sechrest 2001, p. 68)
This becomes clear when considering the subsistence fund in real terms. Once the boom is seen to be unsustainable, cannot entrepreneurs simply sell the overproduced capital goods? Quite possibly, but this will not help to correct the underlying problem. First of all, the prices they will get are sure to be below the present values they originally thought the capital goods to have. Once the contraction begins, demand for capital goods will decline and market interest rates will rise. Both events will drive down their prices. Furthermore, even if entrepreneurs somehow did retrieve the full original value of their investments, all that will have happened is that the economy will have experienced a redistribution of liquidity. What is needed is a greater quantity of real, completed consumer goods. And capital goods cannot immediately be converted into final consumer goods. Changes in the structure of production cannot easily be reversed. There is a significant degree of “path-dependence” involved with the capital restructuring that occurs in the medium run. The economy cannot simply “erase” the errors and start over. Ultimately the only solution is to have a subsistence fund sufficient to meet consumers’ needs. But if that were the case all along, then no boom-bust cycle would have occurred in the first place.
In Diagrammatic Terms How can the components of this ABCT scenario be illustrated? Moreover, how can they be illustrated in terms more-or-less familiar to the typical economics student? In order to respond, one will first need to revisit figures 1 and 2, which show the effects of interest rates on (a) projects’ net present value (NPV) and (b) business investment decisions. Then, to reveal the excessive risk-taking inherent in malinvestment, one can examine figure 3, a modified version of the capital asset pricing model.
Figure 3
In figure 1, the net present value of a project’s stream of discounted cash flows (the vertical axis) is affected by (a) the time needed to complete the project (the horizontal axis) and (b) market rates of interest. This is notably similar to the dimensions of the Hayekian triangle. In such triangles, “[t]he horizontal leg of the triangle represents production time. The vertical leg measures the value of the consumable output of the production process” (Garrison 2001, p. 46). In figure 1 the market interest rate declines, which increases the NPV of all capital projects. However, such increases in NPV accelerate as the time period of the project lengthens. Longer term projects rise in value by a greater percentage than do shorter term projects, for the same initial decline in interest rates. Therefore, as long as businesspeople think that the required complementary inputs will be available, there is always an incentive to undertake longer term projects in an environment of falling interest rates. And, if businesspeople think that the falling rates are a reflection of falling time preferences, they will indeed believe that those complementary inputs will be available when needed.
In figure 2, businesspeople act on the incentives created in figure 1. The market rate of interest (im), initially equal to the natural rate (in), declines to im*. Businesspeople opt for proportionately more higher-order (capital) goods and proportionately fewer lower-order (consumer) goods. This is made possible by the expansion of credit. Yet time preferences have not fallen, so there is no greater subsistence fund than there was before the credit expansion. The gap between the new level of investment expenditures and the subsistence fund is thus unsustainable.
Figure 3 applies a modified version of the capital asset pricing model to ABCT. Here the required rate of return (the vertical axis) should be thought of as the internal rate of return (IRR) on specific capital projects. Risk, on the horizontal axis, is not the systematic risk of an asset, measured by the asset’s β, but the total risk, measured by the variance of the returns to the project (σ2). As the central bank expands the supplies of money and credit, market interest rates fall, so the rate at which cash flows are discounted declines, driving up net present values. But the forecasted cash flows themselves will also rise, since, in an inflationary environment, output prices usually rise faster than do input prices. From both directions, NPVs increase, with the longer term projects exhibiting the greater percentage increases. This makes it appear as if, for the same level of risk exposure, businesses can now enjoy a higher rate of return. The capital market line (CML) seems to rotate upward from CML (actual) to CML (perceived), and businesspeople move toward what they think will be a higher level of utility (U1 to U2). However, in fact this moves businesses into the realm of exceedingly risky—indeed, ultimately unsustainable—capital investments.
Summary Profit, the return to the entrepreneur, is the original form of income, not wages. Wage incomes only come into being when and if capitalists set aside a part of their income instead of consuming it all. Out of these savings comes productive expenditure (or in real terms the subsistence fund), including the demand for labor, because consumers’ demand for final goods is not the source of demand for originary factors of production. The subsistence fund is the source of demand for originary factors and sets the limit on sustainable expansions by identifying the proper intertemporal allocation of resources.
Both malinvestment and overinvestment appear whenever credit expansions are initiated by a central bank, because in such circumstances the subsistence fund will be inadequate to sustain the new, artificially lengthened production process. An excess of money and credit creates the problem. The solution takes time, because real capital goods cannot be transformed into real consumer goods overnight. Monetary changes can be effected rather quickly, but once undertaken, their impacts on real goods cannot easily or quickly be reversed. To view these issues through the lens of the subsistence fund can be very helpful. To do so certainly reminds one that it is capitalist/entrepreneurs who lie at the center of the process, most critically with regard to a distinction emphasized by Rothbard. That is, it is not the gap between saving and credit per se that matters, but the gap between saving in the hands of businesspeople (the subsistence fund) and credit in the hands of businesspeople.
The subsistence fund has really always been an implicit part of ABCT. The verbal and diagrammatic analysis found in the present paper has attempted to make it an explicit part of ABCT. Moreover, in order to more readily convey these essentials of Austrian macro thought to mainstream students of economics, certain rather conventional constructions have been employed. It is hoped that pedagogical considerations, important though they may be, have not detracted from the more important, theoretical objective.
Volume 9, No. 3 (Fall 2006)
Richard Cantillon was the first economist to successfully examine the cyclical nature of the capitalist economy. He lived at a time (168?–1734) when the institutions of the modern capitalist economy were first fully and widely established and the first major business cycles occurred. In contrast to the Mercantilists, Cantillon was an astute observer who developed a clear economic understanding of money, banking, international trade, and stock markets because this is where he risked his capital and earned his fortune. He modeled the economy as an interconnected whole and developed what we now know as the circular-flow model of the economy and the price-specie-flow mechanism of international money movements. He discovered that markets were regulated by the movements of prices based on supply and demand and identified equilibrating tendencies with market exchange.
Volume 11, No. 1 (2008)
The Austrian business cycle theory (ABCT) has been criticized for not being a true theory of the business cycle. The main emphasis of the ABCT has been on the theory of the upper-turning point—the artificial expansion of credit, the manipulation of interest rates, the malinvestments committed by entrepreneurs and then the credit crunch and/or real resource crunch. The paper provides an illustration (from a corporate finance point of view) of how a company, by following market signals, will launch a project that is a malinvestment. The paper then demonstrates how a company can take a failing component from another business and turn it into a viable operation via the liquidation process. This paper then demonstrates how the Austrian theory can make superior recommendations for policies (through the usage of the liquidation process) to help stimulate economic recovery.
Volume 11, No. 2 (2008)
Keynes's presentation of our rates of interest on wheat and housing is set within Austrian business cycle theory, to show that soaring wheat prices and subprime mortgage write-downs are expected, when a monetary authority holds interest rates too low for too long. From that basis, further interest rate cuts are an unlikely remedy for a recession whose roots lie in a proliferation of credit.
The Austrian theory mainly deals with analyzing the effects of an increased credit offer on productive structures. In this respect, we propose to link long-term growth cycles to various short-term interest rate gaps. Are European Business Cycles affected when a fall in the money market rate disrupts agents' expectations of inflation? Using the hypothesis that individual speculation is motivated by the difference between short-term real interest rates and their natural levels, we argue that Wicksellian interest rate gaps can account for a high proportion of long-term fluctuations in four European countries (Germany, France, Italy, and Spain). We present specific dating methods and filters used in order to distinguish between short-term and long-term growth cycles. The Wicksellian incentives we constructed are then significantly linked to long-term business fluctuations. Under the hypothesis of adaptive expectations of inflation, our results are enhanced.
Volume 11, Number 2 (2008)We contribute to the debate over the contemporary relevance of the Austrian Business Cycle theory (ABC) by making three theoretical developments. First, we claim that the heterogeneous nature of entrepreneurship is the best means to respond to a Rational Expectations (RE) critique. If entrepreneurs are different then the "cluster of errors" are not made by everyone, just those on the margin. And if the marginal entrepreneurs are systematically different from the population as a whole, we avoid the implication of widespread irrationality, even though credit expansion will affect real variables. Second, we argue that the size of the monetary footprint is a more telling signal than the market rate of interest, and will not necessarily be revealed by measured inflation. Therefore attention to the official interest rate or Consumer Price Index is misleading, and an inappropriate way to assess applicability. And third, the main harm from loose monetary policy is not that it encourages entrepreneurs to behave more recklessly with capital, but that it encourages precisely the people who can't afford at the market rate to borrow, and makes them the marginal trader. This suggests that adverse selection is a more important issue than moral hazard. We acknowledge that empirical work is required to verify these claims, and suggest how this might be undertaken.
Volume 11, No. 3 (2008)
Ludwig von Mises established the foundations of modem Austrian economics while Irving Fisher established the foundations of modem mainstream macroeconomics and central bank policy. Fisher helped create and was a proponent of mathematical economics, statistics and index numbers, and a monetary policy that "stabilized" the value of the dollar. Fisher claimed that his scientific approach established a New era of prosperity during the 1920s. Mises published a book in 1928 that critiqued Fisher's approach and predicted that it would lead to an economic crisis and collapse. Before the stock market crash in 1929 Fisher proclaimed a perpetual prosperity for the economy and continued to recommend investing in stocks long after the market had collapsed. In this important case study, Mises passed the "market test" while Fisher lost his personal fortune during an economic crisis that his economics help create.
Volume 11, No. 3 (2008) Abstract: Austrian economics is a valuable resource for historians. Scholars informed by Austrian insights can make better sense of historical phenomena, and can provide far better insight into economics history, than those who lack this background. It is impossible to understand events such as the Great Depression with the assistance of no theory at all, so it is essential that the historian adopt the correct one. Sound theory also prevents the historian from falling into a wide array of fallacies — about the stimulative effects of public works projects or the economic benefits of war, for instance — what have insinuated their way into so much scholarly and popular writing.
Keywords: economic history, business cycles, war, methodology When in the early twentieth century history began to emerge in the United States as a professional discipline rather than merely an avocation to be pursued by amateurs and dilettantes, the ideal of objectivity was proposed as a central value of the historian's craft (Novick 1988). The historian, according to this ideal, should in assembling his narrative be committed above all to recording the objective truth, without allowing his own sympathies or allegiances to divert him from his solemn responsibility before the facts. He should be fair-minded and judicious, careful not to favor or unduly disparage any one side.
Eager to make history into a respectable science, some historians made explicit reference to the empiricism of Francis Bacon — who, they said, advocated approaching the object of study without any preconceived ideas, content to consult empirical data and observation as unmediated raw material. Some defenders of the ideal of objectivity went to the extreme of expressly disavowing all preconceived ideas in their approach to the past. Edward Cheyney criticized the practice of "beginning the examination of historical facts ... with any theory of interpretation." Instead, he argued, the "simple but arduous task of the historian was to collect facts, view them objectively, and arrange them as the facts themselves demanded." An honest and competent historian was capable of producing a record of facts that ''when justly arranged interpret themselves" (Novick 1988, pp. 38 39).
But no record of facts, no matter how judiciously arranged, interprets itself. "History,'' wrote Ludwig von Mises, "cannot be imagined without theory. The naïve belief that, unprejudiced by any theory, one can derive history directly from the sources is quite untenable. ... No explanations reveal themselves directly from the facts" (2003, pp. 107–08).
An epistemological dualist, Mises denied that methods appropriate to the natural sciences could be employed in the social sciences, where man, rather than inanimate objects, was the object of study. For one thing, the historian did not have the natural scientist's advantage of a laboratory in which he could observe the consequences of isolating a single factor. "Historical experience," Mises wrote, "is always the experience of complex phenomena, of the joint effects brought about by the operation of a multiplicity of elements" (Mises 1957, p. 208; Mises 1949, p. 31). With laboratory methods unavailable to him, if he was to make sense of historical events the historian could not approach his subject with his mind a tabula rasa but instead needed some acquaintance with social theory, lest he be overwhelmed by data he was helpless to interpret. "The 'pure fact' — let us set aside the epistemological question whether there is such a thing — is open to different interpretations. These interpretations require elucidation by theoretical insight" (Mises 1990, p. 10).
Against the German Historical School and all manner of positivists since, Mises held that there were laws of economics that transcended time and place, and that could be derived by deduction from the so-called action axiom (which holds that human beings act) along with certain subsidiary postulates. Although the laws thus derived were exact, Mises believed that economic analysis was necessarily qualitative rather than quantitative, and that it was a category mistake to expect from them the quantitative precision of physical laws. Because these laws were absolutely true, moreover, they were not subject to revision or rejection on the basis of historical data, which in any event involved the confluence of a multiplicity of events, some amplifying others and some working at cross-purposes with others.
Economic theory, said Mises, is "the indispensable tool for the grasp of economic history. Economic history can neither prove nor disprove the teachings of economic theory. It is on the contrary economic theory which makes it possible for us to conceive the economic facts of the past" (Mises 1990, pp. 11–12). To approach economic history in the absence of theory would surely not bear fruit:
Nowadays [1929] the economic historian seeks to emancipate himself from theory altogether. He disdains to approach his task with the logical tools of a developed scientific theory and prefers to content himself with the small measure of theoretical knowledge that today reaches everyone through the newspapers and daily conversation. The presuppositionlessness of which these historians boast consists, in reality, in the uncritical repetition of eclectic, contradictory, and logically untenable popular misconceptions, which have been a hundred times refuted by modern sciences. (Mises 2003, p. 110)
Mises suggested to his students the example of the comings and goings of people at New York's Grand Central Station (Mises 1957, p. xiv; 1990, pp. 48–49). A purely empirical analysis of this phenomenon would amount to a record of human movements hither and thither, a veritable crazy quilt of data that would shed no light whatever upon the events it studied. Yet if we understood that the human actors we were observing were purposeful beings who aimed at certain ends, we would discover in short order that this seemingly uncoordinated series of movements amounted in most cases to people traveling from their homes to work and back again.
Some level of rudimentary theory — even if at times only a basic understanding of cause-and-effect relationships — is unavoidably present whenever any historian practices his craft. Technically, history comprises anything that has happened in the past — that is to say, its raw data consists of everything that has ever occurred. It is only based on a level of understanding that transcends the raw data that the historian may sensibly discriminate between events that belong in his narrative and those that do not, or whose exclusion would not affect the coherence or accuracy of his account.
A sound theoretical grounding is all the more critical in the study of economic history, for this is a case in which two disciplines meet. Economic historians are typically more knowledgeable about economics than are historians with other specialties, but it is usually the latter who write textbooks for classroom use. Lacking any grounding in economic theory, when such historians inevitably reach those parts of their narratives that require them to delve into economic history they typically adopt whatever appears to be the consensus view of the episode in question, or even whatever view is most in accord with their own political prejudices.
By bringing theoretical knowledge to his study of the past the historian is not approaching his field in a spirit of partisanship that might prejudice his scholarly work. He is merely equipping himself with the kind of intellectual apparatus without which historical scholarship can become either a sterile catalogue of discrete occurrences or — in the hands of an incorrect theory — a misleading record of the past whose poor analysis may encourage unwise policies in the future. No scholar can shed light on economic history if, in a discussion of events A and B, he believes A causes B when A actually inhibits B, or if he does not know the relationship that exists between A and B when in fact a relationship does exist between them. Lacking the proper knowledge in a case like this is sure to lead the historian, and the reader, to erroneous conclusions. One Austrian economist argues that "the benefits to be gained from the study of political economy and philosophy by the historian" include the knowledge he gains "of pure — a priori — social theory, which enables him to avoid otherwise unavoidable errors in the interpretation of sequences of complex historical data and present a theoretically corrected and 'reconstructed,' and a decidedly critical or 'revisionist' account of history" (Hoppe 2001, p. xix). This is how knowledge of Austrian economics can assist the historian.
A monetary history of the United States not informed by sound economics, for instance, would be perfectly useless. The colonial period alone, in which countless newspaper editorials and men of prominence repeatedly urged that a "scarcity of money" in the colonies be resolved by the introduction of paper money (Rothbard 2002, pp. 52–53), is perilous ground for a scholar lacking economic knowledge. The argument in favor of government-issued paper currency as a remedy for a purported scarcity of money appears with such frequency in colonial times that modern historians, lacking any theoretical reason to hold a position to the contrary, have often accepted it at face value.
The Austrian School holds that since the purpose of money is to facilitate exchange, a process that is neither enhanced nor inhibited by its greater or lesser supply, any supply of money above a certain threshold is optimal. Increasing the supply of money serves only to dilute the value of the monetary unit. lts consequences are only negative: distribution effects, calculation problems, even the erosion of traditional moral norms (Woods 2005, pp. 94 97). The historian informed by Austrian economics will therefore be skeptical of historical claims of "shortages of money," as well as of the effectiveness or wisdom of paper money as an appropriate remedy for that alleged problem.
The Austrian historian also possesses his school's theory of the business cycle. No historian worth reading would discuss, say, the Great Depression without so much as a word about what may have caused it. But he can scarcely expect to accomplish that task without the assistance of theory. Murray Rothbard (1983, p. 11), speaking about the historical study of business cycles, wisely cautioned: "Study of business cycles must be based on a satisfactory cycle theory. Gazing at sheafs of statistics without 'pre-judgment' is futile."
Thus the Austrian historian knows that artificially low interest rates created hy the central bank's injections of new money into credit markets deform the economy's capital structure and interfere with the interest rate's normal function of coordinating production across time. The artificially low rates, by artificially stimulating earlier or higher-order stages of production, create an unsustainable mismatch between futureoriented investment plans on the part of entrepreneurs and present-oriented consumption plans on the part of consumers. When confronted in history with an economy-wide downturn, therefore, the Austrian historian knows to tum his attention to monetary factors.
In addition to understanding the causes of the initial downturn, the Austrian historian is also better equipped to think about the recession or depression itself. The recession or depression, he understands, is not the problem per se, but rather the necessary if unfortunate correction process by which the malinvestments of the boom period, having at last been brought to light, are liquidated. Unpleasant as it is, the recession is in fact the period in which the economy restores itself to health, sloughing off and redirecting (where possible) the misdirected capital of the boom. The diversion of resources into unsustainable investments that are out of conformity with consumer desires and resource availability swiftly ceases as unsound investment projects are abandoned.
The Great Depression presents the historian with two truly fundamental questions: what caused the initial downturn, and why did that downturn last as long as it did? For the first of these, as we have seen, the Austrian historian benefits from his knowledge of the Austrian business cycle theory. For the second, he has the advantage of still other insights, each of which leads him to ask the right questions about the historical data. An especially important such insight is that for prosperity to be restored, prices and wages must be permitted to fluctuate freely. Interference with either one of these will hamper the adjustment process, which consists of the reallocation of capital and labor into those lines that most correspond to consumer desires.
The Austrian understands the market's tendency to clear, and thus when it fails to do so, and (among other things) surpluses of labor sit idle for years at a time, he becomes interested to uncover any exogenous impediments to the natural adjustment he expects from the unhampered market. This is not the place to recount in detail all the ways in which government inhibited recovery from the Great Depression, a task that has been ably performed elsewhere (Powell 2003; Rothbard 1983; Vedder and Gallaway 1993, pp. 74–149; DiLorenzo 2005, pp. 156–205; Higgs 2006). In brief: prices and wages, far from being left free to fluctuate, were frozen or otherwise manipulated by government or (later) by the trade associations established under the aegis of the National Recovery Administration. The unmistakably antibusiness posture of Franklin Roosevelt and his advisers also appears to have delayed the recovery, as few entrepreneurs were willing to risk their capital in a radically uncertain environment. Still other policies — sweeping tax increases, special privileges for labor unions, the increased labor costs created by Social Security — likewise inhibited recovery.
Each of these factors is a datum of history, but connecting them to the persistence of the Depression requires knowledge of economics. It likewise requires that the historian understand the nature of wages, and that increasing them through threats of state violence is not a way to provide laborers with more "purchasing power" and thus restore economic prosperity — as indeed just about every mainstream historian takes for granted. Artificial wage increases lead to less employment than otherwise, as simple demand-curve analysis makes clear; and as Jacob Viner put it, "An unemployed laborer has no purchasing power at all, however high may be the wage rate he would get if he had a job" (Phillips et al. 1937, p. 225). ("It would be very nice," said another critic, "if simply by doubling or tripling all wage rates overnight, we could end the depression, but its effect would be rather to make unemployment complete rather than partial" [Phillips et al. 1937, p. 229].)Vedder and Gallaway (1993) discuss the purchasing-power theory of wages in considerable detail.
Still another Austrian insight — or, at least, a point particularly emphasized by Austrians — that can inform sound historical judgments involves the importance of evaluating contrary-to-fact scenarios. Such scenarios involve consideration of what events might have occurred had a particular action not been taken. Had someone not spent his money on a turkey sandwich, for instance, he might have spent it on a ham sandwich, a salad, or on nothing at all, preferring to save his money instead.
More to our purpose would be a case such as this, drawn from the popular press (and even, in some cases, from the professional economics literature): the government institutes minimum-wage legislation, or increases an already-existing minimum wage and, contrary to the warnings of the economists, employment does not fall, and either remains stable or increases. Such employment data, it is alleged, refutes the claim that the minimum wage causes unemployment.
Again, much has been written about the epistemological status of economic laws from an Austrian point of view, and whether or not the data of history can overturn them. Our point here, while not unrelated to that larger question, is more modest: employment under the minimum-wage regime, even if higher than it had been before the legislation was imposed, was still lower than it would have been in a contrary-to-fact scenario in which no increase in the minimum wage had taken place.
Or suppose we read that at some moment in the nineteenth century half of the New England textile industry had been destroyed in a horrific natural disaster, but we also read that the price of textile products was unchanged in the aftermath of this catastrophe, we would not be justified in concluding from this experience that supply has no effect on price. It is precisely because we possess a theoretical grasp of economic concepts that we know how to interpret — or at least how not to interpret — a case like this. Some other factor must have offset the supply cut in order to keep prices stable. And we know that the price of textile products was nevertheless higher than it would have been had this disaster not occurred (here again the counterfactual scenario aids in analysis).
Guido Hülsmann (2003, p. 93) has proposed that "economic science, as a science, begins with Frédéric Bastiat, who stressed the counterfactual relationship between what is seen and what is not seen in human action." Bastiat has himself been described as an Austrian or proto-Austrian on a variety of grounds, not least for his emphasis on counterfactuals. Thus a scholar of Bastiat sums up his major methodological point: "In their trade, economists must rely on deductive theoretical analysis (the unseen) and must not rely on history and statistics (the seen)" (Thornton 2001, p. 393).
Anyone, Austrian or not, can of course evaluate contrary-to-fact scenarios. But the central importance of the contrary-to-fact scenario in the conduct of economic inquiry is fundamental to the theoretical apparatus that informs the Austrian's thought. Economics, said Mises, was the best-developed branch of praxeology, the science of human action. Praxeology begins with the incontestable axiom that human beings act, and develops economic concepts in light of the implications of human action. One such implication of human action is the concept of cost, which in tum is intimately bound to counterfactual analysis (Woods 2005, p. 17). Since the human body is as subject to the constraints of scarcity as any other economic good, and since those constraints limit an actor's ability to pursue more than one course of action at a time, all human action involves cost — namely, the action that is necessarily foregone when the actor chooses a particular course of action. In other words, when an actor performs a, he does so at the expense of performing b. According to Mises, cost "is an element in any kind of human action, whatever the particular features of the individual case may be. Cost is the value of those things the actor renounces in order to attain what he wants to attain; it is the value he attaches to the most urgently desired satisfaction among those satisfactions which he cannot have because he preferred another to it" (Mises 1949, pp. 209–10). From a very early point in praxeological analysis, then, we come face to face with the seemingly obvious but easily overlooked fact that the act of choice always carries some cost: the next-most-valued end that was not taken because the most-valued end was. Because one thing was done, another thing that might have been done was not.
Particular historical episodes, and their evaluation by historians, demonstrate the value of economic counterfactuals in the study of history. One of the New Deal policies that historians have most consistently supported — objecting only that it did not go far enough — is the public-works projects that were designed to provide employment for the jobless. Here, the implication goes, is a program on which all people of good will can agree. In addition to creating jobs, these programs provided important economic stimulus both in their mobilization of resources and in the money they made available to previously unemployed working men, who could now stimulate the economy through the spending that was now possible for them thanks to the income they received from these government-provided jobs.
Here is where the importance of contrary-to-fact scenarios is especially clear. If people are taxed $10 million to fund some government project, they now have $10 million less to spend on things they need. That decline in spending will cost other people their jobs, since taxpayers are now less able, to the tune of the $10 million taken from them, to carry on their previous consumption patterns. Economists John Joseph Wallis and Daniel K. Benjamin (1981, p. 97) have estimated that the publicsector jobs "created" by the New Deal's make-work programs either simply displaced or actually destroyed private-sector jobs.
Henry Hazlitt invited his readers to imagine a bridge project. We can see the bridge being built, and we can see the people doing the building. "The employment argument of the government spenders becomes vivid, and probably for most people convincing," he wrote. "But there are other things that we do not see, because, alas, they have never been permitted to come into existence. They are the jobs destroyed by the $10 million taken from the taxpayers. All that has happened, at best, is that there has been a diversion of jobs because of the project. More bridge builders; fewer automobile workers, television technicians, clothing workers, farmers" (Hazlitt 1946, p. 33).Thanks to Joe Salemo for reminding me of Hazlitt's chapter on make-work programs.
The very existence of the bridge, says Hazlitt, is usually enough to win the argument "with all those who cannot see beyond the immediate range of their physical eyes." They can see the bridge, the direct consequence of the program, but they cannot see the indirect consequences: all the things that were never able to come into existence because the necessary resources were diverted to the bridge, like "the unbuilt homes, the unmade cars and washing machines, the unmade dresses and coats, perhaps the ungrown and unsold foodstuffs." Someone who understands how to assess both the direct and the indirect consequences of government programs — the seen and the unseen, the action that was taken and the actions that might have been taken instead — can see these things in the eye of his imagination, but "to see these uncreated things requires a kind of imagination that not many people have" (Hazlitt 1946, p. 34).
The Austrian historian likewise knows that on net these programs impoverished society, and did not, in a zero-sum game, simply divert jobs from some people to others, or capital from some projects to others. In the private sector, resources must be employed in line with consumer preferences if entrepreneurs wish to see a profit. Otherwise they make losses and must either change their business plans or see their capital slip out of their possession and into the more capable hands of those who are more adept at forecasting consumer demand and allocating capital accordingly. Government lacks this crucial feedback mechanism, since its revenue comes not by satisfying consumers but by the coercive means of taxation. Without having to pass the profit-and-loss test to which the private sector is always exposed, it can never know how relatively efficient or destructively uneconomic its projects are. How much of something is needed, if indeed it is needed at all? Where should it go? What materials should be used? Government cannot answer even these most basic questions of resource allocation in anything bu! an arbitrary manner, as Mises argued in Bureaucracy (1944). Transferring resources from !he private to the public sector, therefore, necessarily involves taking capital ou! of the hands of those who have shown themselves capable of satisfying demonstrated consumer preferences most efficiently, and placing it in the hands of an institution that has no way of knowing consumer preferences in the first place, much less how to satisfy them at the lowest cost.
Although its importance to historians may not be as immediately clear as that of Austrian monetary or business cycle theory, or some of the other examples raised here, the arguments in Rothbard's (1956) important article "Toward a Reconstruction of Utility and Welfare Economics" are still relevant to their discipline. Rothbard begins by emphasizing the subjective nature of value, and that utility cannot be measured, or compared across individuals. It makes no sense for someone to say that he likes his iPod 524.7 times as much as he likes moo goo gai pan, or that he enjoys talking a walk 3.1 times as much as another person does. Now if value is purely subjective, how can we know objectively whether an economic exchange has improved its participants' well-being? According to Rothbard, we are justified in concluding that an exchange has made people better off when both parties voluntarily enter into the exchange. The exchange would not occur in the first place unless each participant believed the exchange would make him better off. An exchange between persons A and B will take place if A prefers B's orange to his own apple, while B prefers A's apple to his own orange. We know that each person valued the other one's good more than his own because we sec their preferences demonstrated in action, in the form of their voluntary exchange of the goods. This is Rothbard's concept of "demonstrated preference."Strictly speaking, we mean to say that in an ex ante sense the exchange has improved someone's wellbeing. It is possible that with the passage of time he may come to regret the exchange; it is also possible that he made a means-ends miscalculation, incorrectly believing that the good or service he acquired in the exchange would help him attain some end when in fact he later discovered that it was not suitable for that purpose.
This insight carries weighty consequences for national income accounting (Rothbard 1983, Batemarco 1987). The Gross Domestic Product is determined for a given year by adding the dollar amounts of private consumption, investment, government spending, and net exports. GDP figures are typically cited as a kind of shorthand for a country's economic well-being, even if they are admittedly not a measurement of national prosperity. But if voluntary exchanges arc the only ones in which we can say for certain that the participants' well-being has increased, the inclusion of government expenditures, which being financed by taxation involve not voluntary exchange but coercion, calls GDP into question as a reliable proxy for a country's prosperity, defined as the well-being of the consumers who comprise it.
Rothbard suggested that government expenditures be altogether excluded from national income accounting, on the grounds that government spending constituted a depredation upon, rather than an addition to, national product. ("Any person who believes that there is more than 50% waste in government will have to grant that our assumption is more realistic than the standard one" [Rothbard 1983, p. 296].) In place of GDP figures. Rothbard proposed instead what he called private product remaining (PPR), which he arrived at by first ''deducting 'product' or 'income' originating in government and 'government enterprise' — i.e., the payment of government salaries-from Gross National Product." This figure is the Gross Private Product, from which Rothbard then deducted the resources that government activity drained from the private sector-namely the larger of either government expenditures or receipts — to get the private product remaining in private hands, or PPR (Rothbard 1983, pp. 296–97).
If economists want an idea of the American standard of living today, therefore, or if historians want to uncover its fluctuations over time, both groups are therefore much better served by calculating PPR per capita rather than following the Department of Commerce and its figures for per capita GDP (Batemarco 1987, p. 185).The argument that government services, even if coercively funded, may still possess some value, is both raised and ansered in Batemarco (1987, p. 185).
Once again, insights like these can help the Austrian historian to avoid just the kind of error that historians lacking such training have been so prone to commit. Among the most egregious is the view that World War II was responsible for economic prosperity, and even for lifting the U.S. out of the Great Depression — a position that, if anything, is even more widespread than the conviction that public-works projects during the New Deal were an economic boon. Seymour Melman summed up the conventional view of World War II: "The economy was producing more guns and more butter. ... Americans never had it so good" ( quoted in Higgs 2006, p. 68).
Insights from the Austrian School are especially helpful in this case, where carelessness and fallacy have combined to yield a conclusion — war makes us prosperous — as absurd as it is widespread. As we have seen, the Austrian has a particular interest in contrary-to-fact scenarios — in this case, what would have happened in the absence of the war? To what purposes might the pertinent resources have been employed? Second, equipped with Rothbard's PPR concept, the Austrian places special emphasis on the health of the private economy, and wants to disaggregate the national accounting figures in order to discover the degree to which the alleged prosperity was actually felt by the ordinary person rather than simply by those with connections to government and who benefited directly from its expenditures.
The best and most systematic work in this area belongs to Robert Higgs (2006). Higgs argues that even prior to any acquaintance with theory, simple common sense should have warned us that something was seriously wrong with official GDP data during the war years.
Consider that between 1940 and 1944, real GDP increased at an average annual rate of 13 percent — a growth spurt wholly out of line with any experienced before or since. Moreover, that extraordinary growth took place notwithstanding the movement of some 16 million men (equivalent to 28.6 percent of the total labor force of 1940) into the armed forces at some time during the war and the replacement of those prime workers mainly by teenagers, women with little or no previous experience in the labor market, and elderly men. Is it plausible that an economy subject to such severe and abruptly imposed human-resource constraints could generate a growth spurt far greater than any other in its entire history? Further, is it plausible that when the great majority of the servicemen returned to the civilian labor force — some 9 million of them in the year following V-J Day — while millions of their relatively unproductive wartime replacements left the labor force, the economy's real output would fall by 22 percent from 1945 to 1947? (Higgs 2006, p. 105)
There cannot be meaningful national-product accounting without market prices, for only market prices reflect voluntary exchanges aimed at improving the wellbeing of each party. During World War II, on the other hand, the U.S. had a command economy full of distorted prices. "In a command economy," writes Higgs, "the fundamental accounting difficulty is that the authorities suppress and replace the only genuinely meaningful manifestation of people's valuations, namely, free market prices" (Higgs 2006, p. 68). The prices the U.S. government paid for the goods and services it bought were essentially arbitrary in that they had no foundation in consumer choice, as all other prices do. Recalling Rothbard's point about voluntary transactions as the only ones we can be sure improve consumers' well-being, we may conclude that the greater the government's coercive power over the economy, the less meaningful in terms of consumer welfare its output statistics become.
Additionally, the more of the economy that the government places into the command system, the more tainted by arbitrariness do the output figures become. During World War II, at least two-fifths of national output was part of the war economy, and large classes of the remainder were controlled in one way or another (and thus arbitrarily priced). The sum of a great many arbitrary, nonsense numbers yields only a gigantic, arbitrary, nonsense number. And yet professional economic historians have relied on nonsense numbers like wartime GDP figures in painting their picture of wartime prosperity. Higgs contends that "the apparent super-trend wartime boom in output was nothing but an artifact of an unjustifiable accounting system" (Higgs 2006, p. 105).
Those figures also obscure the performance of the private economy, which suffered a severe setback during the war and recovered only in 1946. Of course, the official data, for reasons related to our analysis above, tell us that the economy did very poorly in 1946, a time when we know there was great economic prosperity: private output increased by 30 percent that year alone — by far the most extraordinary single-year jump in private output in American history. That, an Austrian knows, is a much better indicator of prosperity: not how much the government is spending, but how much the civilian economy is producing.
These examples give the reader an idea of the advantages that a historian schooled in Austrian economics enjoys vis-à-vis scholars with no such background. They also reveal that objective history and history informed by theory are not mutually exclusive categories. Mises, who described history without theory as impossible, believed that history could be conducted objectively, arguing that "outstanding historians" had managed to "combine scientific aloofness in historical studies with partisanship in mundane interests" (Mises 1957, p. 301).Still, Mises held it to be neither reprehensible nor a violation of the norm of objectivity for historians to exhibit sympathy with their own party or nation. "The postulate of scientific history's abstention from value judgments," he suggested, "is not infringed by occasional remarks expressing the preferences of the historian if the general purport of the study is not affected." Thus if a historian, speaking of an ill-prepared general from his own nation, says that the man was "unfortunately" not up to his task, the writer "has not failed in his duty as a historian." Likewise, the historian "is free to lament the destruction of the masterpieces of Greek art provided his regret does not influence his report of the events that brought about this destruction" (Mises 1949, p. 301). It is not the case, therefore, that impartial scholars approach their subject armed with no theory at all, while those who wish to plead on behalf of a particular cause employ that theory most likely to vindicate their cause.
The use of theory in the study of history docs not compromise the neutrality of the scholar in the face of historical testimony. To the contrary, no history worth reading can be written in the first place if the author divorces his work entirely from theory. Austrian economics in particular provides the historian with a theoretical apparatus that equips him with the ability to make disembodied statistics tell a coherent and accurate story.
Volume 12, No. 1 (2009)
It is with great trepidation and anticipation that we review Robert Shiller’s new book, The Subprime Solution. Trepidation as to the causes of the problem, which were expected to take a behavioral spin. Anticipation that, with gushing reviews from Austrian friendly writers such as Nassim Taleb, there would be a plethora of new insights into the current crisis. However, while the former proved to become reality, the latter was not to be. In fact, Shiller’s two central theses defy all conventional Austrian wisdom concerning the causes and cures of the current financial juncture.
Volume 13, No. 1 (Spring 2010)ABSTRACT: Austrian business cycle theory has a legitimate claim to being the most authoritative explanation of the recent global financial and economic crisis. Indeed, many mainstream economists have begun to analyze the crisis, perhaps unwittingly so, in terms that sound as if they were derived directly from the Mises-Hayek-Garrison theory of macroeconomic fluctuations. Even advanced economic research into financial leverage and liquidity does conceptually little more than develop the framework of Austrian business cycle theory.Jerry H. Tempelman, CFA (www.jerrytempelman.com, j48t@yahoo.com) is an investment analyst in New York City.
Milton Friedman used to say that there is no such thing as Austrian economics—or Chicago economics, or Keynesian economics for that matter. Instead, he noted, there is only good economics and bad economics (Vaughn 1994, p. 105). What makes an economic theory good, Friedman (1953) argued, is the empirical accuracy of the predictions it generates. He rejected Austrian business cycle theory because he did not believe it was an accurate explanation of economic recessions as they actually occurred in practice (Friedman 1993).
Not all economists agree with Friedman’s criterion for the validity of an economic theory—indeed, many Austrians do not. Nonetheless, one wonders whether Friedman, who passed away in November 2006 shortly before the onset of the recent global financial crisis, might have felt differently today about the explanatory power of Austrian business cycle theory in light of that crisis.
This mainstream economist’s understanding of Austrian business cycle theory is roughly as follows. An economic expansion is sustainable if it is the result of an increase in investment that is funded by an increase in saving. In contrast, an economic boom that is merely the result of credit expansion is not sustainable.This starting point is a stumbling block for some non-Austrians, but can be grasped intuitively by realizing that although in the short run one’s purchasing power may be constrained by the size of one’s credit limit, in the long run it is constrained by the size of one’s paycheck. When credit creation by monetary authorities exceeds a society’s structural saving rate, financial intermediaries end up lending money at interest rates that are below the rate where supply and demand clear in the market for loanable funds. As a result, the information embedded in market prices (including interest rates) is distorted, affecting entrepreneurial decisions and causing a misallocation of capital across the economy. Specifically, too many capital goods and not enough consumer goods end up being produced relative to ultimate consumer preferences. Eventually, as the lack of underlying demand for these capital goods becomes apparent, production capacity is idled, and the boom that was fed by the credit expansion turns to bust. Thus, credit expansion during an economic downturn will not help bring about a sustainable boom but will merely postpone it, as it causes a delay in the structural adjustments, such as business closures and other eliminations of unproductive uses of capital, that need to be made to bring about a sustainable economic expansion.
With the benefit of hindsight, the preceding paragraph would appear to be a summary description of what has happened to the financial system and the macroeconomy in recent years. The 2002–2007 expansion was characterized by both monetary accommodation and a boom in residential real estate. The boom proved unsustainable, and was followed by a spectacular bust in both the financial markets and the broader economy.
Indeed, predictions by Austrian or Austrian-inspired economists such as William R. White, Economic Adviser and Head of the Monetary and Economic Department of the Bank for International Settlements from May 1995 to June 2008, have been uncanny not just in their accuracy but in their specificity. Just before the onset of the crisis, White (2006, p. 1) pointed out that “persistently easy monetary conditions can lead to the cumulative build-up over time of significant deviations from historical norms—whether in terms of debt levels, saving ratios, asset prices or other indicators of ‘imbalances.’” To be sure, a financial crisis of sorts had also been forecast by many non-Austrian economists, such as Nouriel Roubini and Stephen Roach. But their predictions tended to focus more on macroeconomic imbalances such as the current account deficit or the federal government debt. White and other Austrians, on the other hand, were more precise in predicting that a crisis would be triggered by a collapse of an asset bubble, specifically the real estate bubble.
In August 2003, for example, in a presentation at the annual economic symposium of the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming, White argued that “the unusually buoyant behavior of housing prices in the current slowdown may well be related to the substantial monetary easing undertaken by central banks…. [This] has encouraged a further rise in indebtedness in the household sector in a number of countries, raising the risk of contributing to balance sheet overextension there, especially if housing prices were to soften.” Eventually, “if the worst scenario materializes, central banks may need to push policy rates to zero and resort to less conventional measures, whose efficacy is less certain” (Borio and White 2003, pp. 172, 175). Just as White predicted, in December 2008 the Federal Reserve lowered the target for its conventional policy variable, the federal funds rate, to a range of 0 to 0.25 percent. And the Fed has resorted to less conventional policy measures, by providing support to specific sectors of the credit markets throughout the crisis and by targeting longer-term interest rates through the purchase of U.S. Treasury securities in 2009.
White’s views were largely ignored by central bankers at the time he expressed them prior to the crisis, when they were often pitted against the views of then Federal Reserve Chairman Alan Greenspan. At that time, Greenspan was widely heralded for having recognized a major shift in the mid-1990s, namely a sharp increase in economic productivity. As a consequence, the Federal Reserve did not increase interest rates in the way it previously would have done. This is what was thought to have allowed the expansion of the 1990s to continue and become the longest in more than a century, as an earlier tightening of monetary policy might not have delayed the next economic recession until its eventual occurrence in 2001.
But the accommodative monetary policy of the 1990s was not without consequence, and amidst the praises lavished on Mr. Greenspan, some criticism could be heard as well. In a guest editorial in Barron’s in the summer of 2002, for example, even as the economy was still in the aftermath of the 2001 recession, William C. Dudley, then chief economist of the investment bank Goldman Sachs, attributed the late 1990s stock market bubble to the Fed’s low-interest rate policy that coincided with it:
In my opinion, the nation’s monetary authorities should have tightened policy earlier and more aggressively during the 1996–1999 period. A tighter monetary policy might have helped to keep the investment boom from becoming so extended. As a consequence, the downward forces of adjustment that followed when the boom ended would not have been so intense. Also, the allocation of capital might have been improved. After all, with hindsight, it is pretty obvious that billions of dollars of investment spending in sectors such as telecom were wasted.
Mr. Dudley is today president of the Federal Reserve Bank of New York and vice chairman of the Federal Open Market Committee (FOMC). He is not typically considered among the more hawkish, hard-money members of the Committee, but an Austrian would find little with which to disagree in Mr. Dudley’s analysis.
In September 2002, a survey in The Economist echoed Mr. Dudley’s assessment: “Without easy credit the stock market bubble could not have been sustained for so long, nor would its bursting have had such serious consequences. And unless central bankers learn their lesson, it will happen again” (Woodall 2002). The Economist was explicit in acknowledging Austrian business cycle theory: “The recent business cycles in both America and Japan displayed many ‘Austrian’ features” (ibid).
Four years later, The Economist would even cite Ludwig von Mises in pointing out that the Fed’s overly stimulative monetary policy following the 2001 recession was not without longer-term consequences: “The words of Ludwig von Mises, an Austrian economist of the early 20th century, nicely sum up the illusion: ‘It may sometimes be expedient for a man to heat the stove with his furniture. But he should not delude himself by believing that he has discovered a wonderful new method of heating his premises.’”“Danger time for America,” The Economist, 14 June 2006, p. 15. The citation is from Mises (1998 [1949], p. 650). A year later, in the summer of 2007, those longer-term consequences would become apparent to everyone.
Since the crisis, Mr. Greenspan’s luster has considerably diminished, while that of Mr. White has considerably increased.For an excellent background article on White, please see Balzli and Schiessl (2009). The notion that the prosperity of the latter years of the Greenspan era was a succession of bubbles is now held even by many non-Austrians. Particularly noteworthy is the opinion of that Keynesian par excellence Paul Krugman, who once dismissed Austrian business cycle theory as a “hangover theory” (Krugman 1998) before going on to assert that “the Fed’s ability to manage the economy mainly comes from its ability to create booms and busts in the housing market” (Krugman 2005).
The Wall Street Journal editorial page, which is ideologically not quite Mr. Krugman’s soul mate, would subsequently use the “hangover” moniker in a 2006 editorial:
After the party sometimes comes the hangover, which is what much of the country is now experiencing as the housing market comes back to Earth following several years of remarkable levitation…. This is the housing market the Federal Reserve built. That is to say, the current slump in sales, new construction and prices is the aftermath of the astonishing and unsustainable housing boom that began in 2002…. The Fed’s mistake was staying too easy for too long…. One result is what now looks to have been a classic asset inflation in housing values.“The House the Fed Built,” Wall Street Journal, 25 August 2006, p. A14.
Hangover or not, many Austrian economists would argue that, for better or for worse, Krugman and the Wall Street Journal editorial writer were correct in their assessment of the Fed’s conduct of monetary policy following the 2001 recession.
It is not straightforward to demonstrate conclusively that the low federal funds rate of 2003 and the following years is indeed what caused the housing boom. Interest rates on residential mortgages that finance home purchases tend to track more closely to the 10-year U.S. Treasury yield, which the Federal Reserve neither targeted nor controlled at the time, than to the federal funds rate, which it did. In 2003–04, when the Federal Reserve brought the federal funds target rate all the way down to 1 percent, 10-year U.S. Treasury yields and both 1-year adjustable and 30-year fixed mortgage rates did not drop nearly as much. Arguably there were other factors that contributed to the crisis—the all-too-often used perfect storm analogy would appear to apply in this instance. Still, the coincidence of the low federal funds rate with the onset of the housing bubble in the spring of 2003 in, say, Las Vegas, where the housing boom and bust have been most pronounced, is remarkable.
Indeed, several mainstream scholars, using different methods of scientific inquiry, have concluded that the Fed’s accommodative monetary policy following the 2001 recession caused, or at least was a principal contributor to, the housing boom that followed. Taylor (2007) argues that from 2002 through 2005, U.S. monetary policy was far more accommodate than a rule-based approach would have called for based on an interpretation of inflation and output data. Correlating historical housing starts and interest rates, he finds that housing starts during 2003–06 were meaningfully higher than they would have been if the Fed had followed the more restrictive rule-based monetary policy after the 2001 recession. Jarociński and Smets (2008), using a Bayesian vector autoregression estimate for the U.S. economy that includes a housing sector, conclude that there is
evidence that monetary policy has significant effects on housing investment and house prices and that easy monetary policy designed to stave off perceived risks of deflation in 2002–04 has contributed to the boom in the housing market in 2004 and 2005. (p. 362)
Smithers (2009) blames the financial crisis on “the actions of incompetent central bankers, who provided excessive liquidity on which the asset price bubbles and their associated absurdities were built” (p. 3). This is because “interest rates affect asset prices and, as asset prices affect the economy, this is a major transmission mechanism whereby central banks influence demand in the real economy” (p. 5). Vogel (2010) finds that “interest-rate policy levers such as Fed funds rates appear to have some effect on the creation and sustainability of bubble conditions.” This process runs approximately as follows: “bank credit creation begins with decreases in non-borrowed reserves that then work through to increases in business and/or consumer lending.” But “once such lending exceeds what can be readily absorbed by or used for GDP transactions, the excess spills over into incremental demand for shares and/or other leverageable financial assets, including real estate and commodities” (p. 224).
MAINSTREAM ECONOMICS RESEARCH ON THE CUTTING EDGEEconomists both inside and outside the Federal Reserve today widely point to the Fed as the main culprit behind the two greatest economic calamities of the past century: the Great Depression of the 1930s, when—according to mainstream economic theory—monetary policy was essentially too tight (Friedman and Schwartz 1963, Bernanke 2002, Meltzer 2003), and the Great Inflation of the 1970s, when monetary policy was too accommodative (Meltzer 2009). It is too early to be definitive, but the idea that the Fed’s accommodative monetary policy following the economic recession of 2001 was the main cause of, or contributor to, the housing bubble, the collapse of which triggered the broader financial and economic crisis, is becoming increasingly widespread even among non-Austrians.Stanford economist John B. Taylor initially proposed his theory at the August 2007 Jackson Hole, Wyoming, symposium of the Federal Bank of Kansas City (Taylor 2007). Federal Reserve Chairman Ben S. Bernanke replied in a speech at the January 2010 annual meeting of the American Economic Association (Bernanke 2010), but in a survey by the Wall Street Journal shortly after that speech, 42 Wall Street and business economists agreed with Taylor’s argument while only 12 sided with Bernanke’s. A concurrent survey of members of the monetary economics program of the National Bureau of Economic Research found that 13 members agreed with Taylor’s argument, while 14 agreed with Bernanke’s (Hilsenrath 2010).
Even cutting-edge mainstream economic research, such as that in areas of financial leverage and liquidity, does conceptually little more than developing the framework of Austrian business cycle theory. For example, mainstream economists have begun to identify links between monetary policy and financial leverage, or debt. New York Fed President Dudley (2009) recently noted that “[t]here is a growing body of economics literature on this issue that links monetary policy to leverage.” Dudley cited research by Tobias Adrian and Hyun Song Shin (2009), who identify what they call a “‘risk-taking channel’ of monetary policy,” and find that short-term interest rates—the Fed’s main monetary policy variable—are an important factor in influencing the amount of financial leverage employed by financial intermediaries. According to a recent Wall Street Journal article, “[Federal Reserve Chairman Ben] Bernanke has been following Mr. Adrian’s work closely” (Hilsenrath 2009). These research efforts are to be applauded, but causal links between overly accommodative monetary policy, excessive financial leverage, insufficient saving, and unsustainable asset prices are, of course, a core part of the Austrian explanation of business cycles.
Likewise, research in liquidity, which finds that an asset’s market liquidity (i.e., the ease with which an asset is bought or sold) and traders’ funding liquidity (i.e., the ease with which traders can obtain funding) are related and mutually reinforcing (Brunnermeier and Pedersen 2009), is substantively no more than a fleshing out of the Austrian framework. Economist Markus K. Brunnermeier argues in a recent interview that “macroeconomics will change.... Its models ignored the main components of the crisis. What will happen is that macro will merge with the field of financial frictions, giving rise to a new economics” (Adler 2009, p. 25). Well, fine, but the integration of macro-, micro-, and financial economics into a single coherent theory has long been a distinguishing feature of Austrian economics.
Even so-called behavioral explanations of business cycles, including the recent financial crisis (e.g., Shiller 2008), may be viewed as complementary rather than contradictory to Austrian business cycle theory, although Roger W. Garrison’s (1996, p. 16) analogy of the 1906 earthquake of San Francisco applies. In that disaster, more damage was done by the fires that followed the earthquake than by the earthquake itself, but the fires were at best “a secondary phenomenon” that would presumably not have occurred if not for the earthquake. According to mainstream economic research, bubbles are characterized by an increase in trading volumes, especially by nonprofessional or inexperienced investors (Greenwood and Nagel 2008). Nonprofessionals do not enter a market just because the cost of funding is low. They enter a market because they are under the impression that making money is easy. But the reason why they are under that impression is that professionals have been making money in what in retrospect looks like an easy manner, and professionals have been able to do so in part because of a cheap cost of funding that made possible increased financial leverage. Thus, the sequence is from accommodative monetary policy to a low cost of funding to an increase in the use of financial leverage by professional investors, who buy assets and generate earnings in doing so, and are followed by nonprofessional investors who lack the skills to rationally value assets and end up bidding up asset prices accordingly. Even non-Austrians are likely to agree that this is not sustainable.
LESSONS LEARNED, LESSONS REMAININGThere are some positive signs that Federal Reserve officials are learning from the experience of the recent crisis. Current and former FOMC members have acknowledged that they kept monetary policy too accommodative for too long following the 2001 economic recession. In an interview on PBS’s Charlie Rose Show in May 2009, former FOMC Vice Chairman Timothy F. Geithner stated that “monetary policy around the world was too loose too long.”Available at http://www.charlierose.com/view/interview/10278. Dallas Fed President Richard W. Fisher (2006) has said that because of poor inflation data, “the real fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer than it should have been.”
To their credit, members of the FOMC have also become mindful of the potential dangers of maintaining an ultra low federal funds rate for an extended period. According to the minutes of the November 2009 FOMC meeting (p. 9), “[m]embers noted the possibility that some negative side effects might result from the maintenance of very low short-term interest rates for an extended period, including the possibility that such a policy stance could lead to excessive risk-taking in financial markets or an un-anchoring of inflation expectations.”
In addition, the financial crisis appears to have made Fed officials more open to reconsidering previously held beliefs, for example with regard to whether the Federal Reserve should try to target not just consumer price inflation but also asset prices. One rather suspects that this notion is anathema to libertarian-minded Austrian economists, who can scarcely be deemed to favor a committee of twelve or fewer people, no matter how capable, how well supported, how well intentioned, and how politically diversified, determining what asset prices should be. It is one thing for central bank officials to consider a variety of both economic and financial indicators, in order to ascertain not just inflation and unemployment conditions but also trends in the magnitude of credit outstanding, as part of evaluating whether monetary policy is perhaps too restrictive or too accommodative. But it is quite another for central bankers to be able to detect and actively try to deflate a possible asset price bubble in the making.
A more useful idea currently gaining favor is of a more symmetrical application of monetary policy, in which central banks no longer raise interest rates less during an expansion than they lower them during a recession (White 2006, p. 15; Cooper 2008, pp. 35–36). Austrians propose even more drastic changes in monetary regime, such as the abolition of central banks entirely and their replacement with a gold standard and systems of free banking and currency competition. Mainstream economists have long objected to such ideas primarily on grounds of economic inefficiency. It is inefficient, for example, for an economy to have multiple currencies issued by multiple parties. Still, in the wake of the crisis, ideas for alternative monetary regimes have perhaps been dismissed too easily, just as Austrian business cycle theory was once dismissed. Considering that theory’s accuracy in predicting and explaining the recent crisis, to this mainstream economist, at least, ideas for alternative monetary regimes merit greater consideration than they have received to date.
Volume 13, Number 3 (Fall 2010)
This paper contrasts mainstream analysis of the recent boom/bust episode and its massive interventions with Austrian business cycle theory (ABCT). Mainstream economists remain lost in the Keynesian jungle, and economists in the vein of Irving Fisher, Milton Friedman and Martin Feldstein have not helped. The blinkered approach favored by the economics profession ignores the business cycle theory pioneered by Ludwig von Mises and deepened by successors like Murray Rothbard and Jesús Huerta De Soto. Defying standard economic theory, economists implicitly believe that artificially low interest rates (wrong prices) and debt piled on debt unbacked by real savings do no harm to resource allocation and employment. Attempts to hasten economic growth via monetary policy must prove self-defeating by seducing businesses to over invest in higher stages of production and under invest in lower stages. The recession is the realignment of the production structure with consumer wants. “Without a sound capital theory, macroeconomics is incomprehensible,” as Larry J. Sechrest wrote.
Volume 14, Number 2; Summer 2011
This paper investigates the potential systemic risks posed to the U.S. securities markets by the banking crisis during the Panic of 1907. Past studies of 1907 have focused almost exclusively on the banking crisis. Our study examines the mechanisms that minimized the spillover of the banking crisis, and allowed the U.S. capital markets to remain not only open, but also relatively liquid, during the crisis. We show that contractual arrangements in the securities markets helped to minimize spillover effects, and that global arbitrage of U.S. securities allowed the U.S. to draw significant liquidity from European markets in times of crisis.
Volume 14, Number 1 (Spring 2011)
Paolo Sylos Labini (1920–2005) was the one of the most influential economists in Italy after the Second World War. After graduating in 1942, Sylos Labini won a fellowship in the USA. After an initial period in Chicago, he moved to Harvard, where he was able to attend Schumpeter’s lectures from 1948 to 1950. During this period, Sylos Labini read Schumpeter’s Business Cycles and decided to write down his impressions before giving them to his former professor in February 1949, who discussed them over a couple of lessons. These notes are still unpublished, and Sylos gave me a copy at our first meeting (2002), saying that it was time to publish them. This paper discusses the content of the unpublished notes, focusing on the critical aspects of Schumpeter’s business cycle theory to which Labini draws attention. In the last section, I present Sylos Labini’s business cycle theory, an interesting mix of Schumpeterian, Keynesian and Marxian elements.
Volume 14, Number 3 (Fall 2011)
Hayek is seen as one of the main opponents of Keynes because of the debate about macroeconomics that they had in the early thirties. A few years after this controversy, Keynes published The General Theory (1936), and Hayek was expected to criticize Keynes’ new model. But, surprisingly, Hayek decided to remain silent and let his opponent go unchallenged. He regretted it ever after. However, this paper argues that in Hayek’s work after 1936, there is a criticism of The General Theory that to a certain extent has remained unnoticed. Thus, this approach reopens the great debate between Hayek and Keynes just where they had apparently left it, that is, after the publication of The General Theory.
Volume 13, Number 2 (Summer 2010)
This paper is a review of Austrian School references in business cycle studies published by the National Bureau of Economic Research. The NBER’s business cycle chronology is limited by its exclusion of the Panic of 1819, described by Rothbard (1962). Another limitation of most NBER cycle literature is a non-reliance on historical accounts. NBER cycle studies focus on the Hayekian version of Austrian business cycle theory (ABCT), an endogenous theory. They overlook exogenous Misesian and Rothbardian versions of ABCT. Business annals were used by Mises, Hayek, and Rothbard, and are part of the Austrian tradition. Annals appear in NBER cycle studies starting with Thorp (1926) and ending with Zarnowitz (1992).
Volume 13, No. 3 (Fall 2010)
Recognizing different types of savings allows for a more fruitful analysis of the business cycle. Sustainable investment activities must be financed by an equivalent amount of savings, both in length of availability and quantity. Upward-sloping yield curves are a feature of the unhampered loanable funds market. Interest rates differ along this curve depending on the investment community’s demand for funds. While free market maturity mismatching can be successful and advance intermediation, the existence of either a central bank or a fractional reserve banking system skew the yield curve, resulting in malinvestment fueled boom-bust cycles. Credit expansion alone fails to explain the full extent of these cycles. Additional causes of the business cycle are found via excessive maturity mismatched borrowing driven by three banking sector interventions: credit expansion, the provision of a lender of last resort, and government bailout guarantees.
Volume 4, No. 3 (Fall 2001)This book is a long-awaited project among Austrian economists; some of the central contributions found in the book date back nearly a quarter of a century. The consensus of opinion is that it has been worth the wait and that the book is an important contribution to Austrian economics as well as to the comparative study of macroeconomics schools of thought. Some contributors tended to emphasize the unique analytical contributions of the book, while others tended to focus on its value as an expository device. Many noted that it could provide the platform for the next generation of Austrians to make substantive advances in the area of macroeconomics and capital theory.
Volume 13, Number 4 (Winter 2010)
The Cantillon effects cited in Thornton (2005) are a consequence of the central bank, and result in entrepreneurial errors during expansions in the NBER’s US business cycle chronology. Completion of the Woolworth Building and other skyscrapers coincide with NBER-identified contractions when the errors are revealed. Effects are also evident at the non-national level, including the sister states of Arkansas and Michigan, where the Dime, Penobscot, Renaissance Tower, Pyramid Life, Union Life, Donaghey, Tower, Bank of America and Region’s Bank buildings were completed around contractions. The tallest or once-tallest buildings in forty states were completed in NBER-identified contractions.
Volume 13, Number 3 (Fall 2010)
Rothbard (1963) provides a compelling explanation of the Great Depression. He used the Austrian business cycle theory to show that the inflationary policies of the Federal Reserve caused a boom in the economy of the 1920's that led to a bust in 1930. He then employed the Austrian theory of interventionism to show that Hoover’s policies were highly interventionist and caused the depression to be “great.” The combination of theories can be used to explain the stagflation of the 1970s, Japan’s lost decade of the 1990s, and the current economic crisis, which is now the longest contraction since the Great Depression. Like Hoover, George W. Bush had a reputation as an advocate of laissez faire policy. However, he presided over a massive expansion in the size of government and deployed highly interventionist policies to address the crisis.
Volume 13, Number 3 (Fall 2010)
Most historians claim that Herbert Hoover adhered to a policy of laissez faire after the stock market crash of 1929. This laissez faire policy is allegedly responsible for the severity and persistence of unemployment during the early years of The Great Depression. Herbert Hoover actually reacted to the crash of 1929 by urging industrial leaders to keep money wages high. Hoover believed that high wages would support consumer spending and spur recovery. This paper extends the hypothesis advanced by Rothbard (1972) that Hoover’s high wage policy intensified and prolonged unemployment during the depression. Analysis of wages and employment in specific industries indicates that Herbert Hoover successfully increased real wages. There are strong correlations between real wages and employment losses in the industries that Hoover intended to influence. The evidence indicates that Hoover’s activist high wage policy prolonged and intensified unemployment during the early years of the Great Depression.
Volume 4, No. 3 (Fall 2001)Garrison's Time and Money picks up where Hayek left off, developing a macroeconomic model based on Austrian capital theory that provides significant insights into macroeconomic phenomena. My title here is slightly misleading: how does one count contributions? In one sense, Garrisons's Time and Money makes more than two contributions, but in another way, maybe the whole book should just count as one contribution. The two contributions referred to in the title here are the book's contributions to macroeconomics and to Austrian economics, which are sufficiently distinct that they can be counted separately.
Volume 4, No. 3 (Fall 2001)Professor Garrison’s work in Austrian macroeconomics over the past twenty-plus years has been most influential. Time and Money and its detailed development of a capital-based macroeconomics is the most important of these recent developments. The capital-based approach has the advantage of providing a seamless macroeconomics of the short run, the medium run, and the long run, particularly when compared to current mainstream analysis, which lacks a medium run and has long-run and short-run models that are often in conflict. Cochran and Glahe argue that it is only with a “greater understanding of the forces actually shaping events in a monetary production economy that we can make rational decisions about policy and monetary institutions.” Time and Money is certainly a major contribution to our further understanding of these complex market processes.
Volume 6, No. 1 (Spring 2003)In a recent study, Keeler (2001) attempts to provide historical/empirical evidence for the Austrian business cycle theory by examining the effect of interest-rate changes on various components of investment spending (classified arbitrarily as early- or late-stage investment) and consumer spending. Our analysis implies that such research is likely to be misleading. The important causal feature is not the change in observed interest rates, or even changes in interest rates relative to the natural rate, but the amount of circulation credit and whether the credit issued is initiatory, as in the benchmark case, or reactive, as in the productivity shock case and the saving decline case.
Volume 4, No. 3 (Fall 2001)Time and Money is a multifaceted achievement. Within its pages the reader will encounter business cycle theory, capital theory, comparative economic thought, and many contemporary macroeconomic topics, as well as the tools needed to convey all of it to university students. Academic economists, regardless of school of thought, should welcome this book. It is lucidly written and well-organized, and every page reflects the years of thought that Garrison has devoted to these subjects. One manifestation of this is the fact that throughout the book he successfully navigates between the Scylla of pedagogical simplicity and the Charybdis of theoretical complexity. The net result has just the right proportions of the two.
Volume 6, No. 2 (Summer 2003)Austrian business cycle theory (ABCT), we contend, is essential to understanding the recent boom and bust cycle in the American (and, to a great extent, the global) economy. That does not mean that every recent macroeconomic event is explained by ABCT. For instance, exchange rate manipulation (e.g., the Reverse Plaza Accord) is not a part of standard ABCT, yet it played a key part in the global macroeconomic picture of recent years. However, as long as central banks continue to engage in episodic credit expansion, we believe that ABCT remains a vital component in the macroeconomist’s tool chest.
Volume 4, No. 3 (Fall 2001)I would like to emphasize two implications of my argument. First, the concept of secular growth as an uncaused phenomenon contradicts the Mengerian method of analyzing dynamic market processes as well as modern Austrian capital and interest theory and should be purged from capital-based macroeconomics. In its place should be substituted a causal analysis that accounts for the stylized fact of a steady secular growth trend in industrial economies in terms of the dynamic coordination of entrepreneurial plans with the historical development of time preferences, the size and quality of the labor force, natural resource endowments, and technological progress. This substitution can easily be made without in the least affecting the basic structure of the Garrisonian analytical framework. Second, and more important, the analytical simplification of the loanable funds market, while it may be a useful component of capital-based macroeconomics in treating the effects of changes of preferences and policies that impinge on the supply side of the intertemporal market, is liable to be dangerously misleading when dealing with demand-side influences on the capital structure. Consequently, perhaps a richer conception of the time market could be formulated and incorporated into capital-based macroeconomics without seriously damaging its potential appeal to mainstream macroeconomists.
Volume 17, No. 1 (Spring 2012)ABSTRACT: The financial crisis and the events leading up to it have sparked a remarkable renewal of interest in Austrian Business Cycle Theory (ABCT). A number of mainstream macroeconomists have criticized this resurgence of interest in ABCT on the grounds that the theory cannot explain the positive correlation of consumption and investment that occurs over the course of the business cycle. They allege that the theory predicts a slump in investment and capital goods’ industries and a corresponding boom in consumption during the recession. They therefore conclude that ABCT is manifestly in conflict with the stylized facts of the business cycle. In this paper I respond to these claims. I argue that the mainstream interpretation misrepresents essential features of the theory and conflicts with its presentation by its leading proponents. I then present an alternative formulation of the theory based on the works of Mises, Hayek and Rothbard. I argue that this version does satisfactorily account for the overconsumption boom and subsequent retail slump that were such conspicuous elements of the boom-bust cycle that played out over the past decade.
KEYWORDS: Austrian, business cycle, financial crisis, Mises, Hayek, RothbardJEL CLASSIFICATION: E32, B53INTRODUCTIONThe financial crisis and the events leading up to it have sparked a remarkable renewal of interest in Austrian Business Cycle Theory (ABCT). Several high profile investment advisers and financial commentators have employed the ABCT in their interpretation of the crisis. They have been inspired to revisit this theory as a result of the manifest failure of mainstream macroeconomists to foresee or explain the subprime mortgage crisis and its subsequent metamorphosis into a pandemic financial meltdown that led to the longest recession since World War II. Interest in the theory was reinforced by the fact that a number of economists and journalists associated with the modern Austrian school had warned of an emerging housing bubble during the Greenspan era when the conventional wisdom was that the Federal Reserve System had matters well in hand (Thornton, 2009).
Some prominent (and not so prominent) mainstream macroeconomists have not responded kindly to the sudden resurgence of interest in ABCT. But rather than openly subjecting the theory to rigorous, scholarly analysis in the standard research forums of academic journals and professional conferences, they have sniped at the theory on blog sites and in the popular press. Furthermore, in their haste to find flaws in the theory, they have disregarded the works of its originators and leading proponents, such as Ludwig von Mises, Friedrich A. Hayek, and Murray Rothbard. Instead they have drawn upon a single secondary source that portrays ABCT as a “monetary overinvestment theory” of the business cycle. The theory is thus described in the influential survey of business cycle theories published under the auspices of the League of Nations in 1937 by Gottfried Haberler (1963, pp. 33–72).Although Haberler was initially a supporter of ABCT, by 1933 he had become a critic of the theory and in his later career migrated to the position of moderate establishment Keynesian, although his writings still evinced his early Austrian orientation. For evidence of Haberler’s intellectual migration and lingering traces of his Austrian training, see Haberler (1933, p. 99; 1974; 1996); Ebeling (2000) and Salerno (2005). The result is that their criticisms are aimed at a theory that grossly misrepresents ABCT in essential respects.
The gist of their critiques is that ABCT cannot explain the positive correlation of consumption and investment that occurs over the course of the business cycle. In particular they allege that the theory predicts a slump in investment and capital goods’ industries and a corresponding boom in consumer spending and retail sales during the recession. They therefore conclude that ABCT is manifestly in conflict with the stylized facts of the business cycle and should not be seriously entertained.
The central thesis of this paper is that ABCT, rightly understood, does satisfactorily account for the overconsumption boom and subsequent retail slump that were such conspicuous elements of the boom-bust cycle that played out over the past decade. In arguing my case, I clarify or reformulate ABCT on several points. First, I document and emphasize the neglected point that the Austrian theory is not an “overinvestment theory” of the business cycle and was never construed as such by its most notable proponents. Second, I explicitly extend the analysis of the effects of the central bank’s manipulation of interest rates from entrepreneurial choice among the length of production processes to household choice among intertemporal consumption patterns. Most accounts of ABCT focus almost solely on the “malinvestments,” that is, the intertemporal misallocations of resources, which are induced by the permanent gap between the loan rate and the natural rate of interest created by expansionary monetary policy. By formally integrating the “wealth effect” into ABCT, I am able to show how the illusory profits and inflated factor incomes and asset prices caused by money and bank credit expansion promote the falsification of households’ assessment of their net worth and the distortion of their consumption/saving choices. Thus the overconsumption that is typically observed during the boom is established as a coordinate effect with entrepreneurial malinvestments in the production structure attributable to the same cause: the distortion of the interest rate by monetary expansion. Whether one or the other effect predominates during a given boom depends on the historical data. My third refinement of ABCT is to link the so-called “secondary deflation” to the pervasive malaise and waning of “animal spirits” among the mass of entrepreneurs that occurs when the recession reveals their cluster of miscalculations and errors and saps their confidence in their ability to identify and calculate profitable investments. I argue that the secondary deflation is not the result of an incidental monetary contraction that depresses some arbitrary price level; rather it is a reaction to and correction of the relative price distortion caused by the extreme overbidding of factor and asset prices during the euphoria of the boom. When allowed to run its course, this relative price adjustment inevitably re-establishes a natural interest rate sufficiently high to stimulate capitalists and entrepreneurs to dishoard cash and actively seek out investment opportunities. When stunted by “quantitative easing” and fiscal deficits driven by stimulus programs, the entrepreneurial malaise becomes chronic, and economic stagnation ensues.
In section 2, I briefly delineate the dimensions of the recent retail slump, and show that, in several respects, it was indeed unprecedented. The criticisms of ABCT by mainstream macroeconomists alleging that the theory cannot account for such a development are surveyed in section 3. I respond to these criticisms in section 4 arguing that ABCT is not an “overinvestment theory” at all. Rather, I argue, both “malinvestment” and “overconsumption” occur contemporaneously during the boom and whether one or the other effect predominates is determined by concrete historical circumstances. I also indicate how my argument differs from that presented by Roger Garrison (2001, 2004), which reaches the same conclusion by a different route.Although several criticisms are aimed at his argument below, they do not diminish the significance of Garrison’s achievement in drawing the attention of contemporary economists to the overconsumption effect in ABCT. Section 5 discusses the overconsumption and “capital consumption” that occurred during the boom leading up to the financial crisis and gives a summary assessment of their magnitude and relation to the ensuing retail slump. I outline the implications of my reformulation for the analysis of the phenomenon of “secondary deflation” in section 6. I conclude in section 7.
- THE RETAIL SLUMP IN THE GREAT RECESSION OF 2007–2009.Perhaps the most prominent feature of the recent recession in the U.S., aside from the collapse of the housing sector, was the exceptionally severe retail slump that characterized it. One indication of its severity was the precipitous decline in retail and food service sales. For December 2008, the year-over-year decline in current dollar sales was 11.1 percent and from January though July 2009 these year-over-year declines fluctuated between 8.5 percent and 10.5 percent (Federal Reserve Bank of St. Louis [2010b]).All data on retail sales and consumption are drawn from this source unless otherwise noted. Except for two nonconsecutive months during the recession of 1990–1991 in which the percent change in monthly retail sales dipped slightly below zero on a year-over-year basis, one would have to go back to 1960–1961 to find declines in current dollar retail sales during a recession, although nothing like the magnitude experienced during the latest recession.The data for the retail sales series prior to 1992 is not strictly comparable to the data on retail sales and food services from 1992 to the present since the former are on an SIC (Standard Industrial Classification basis and the latter on an NAICS (North American Industry Classification System) basis. See Federal Reserve Bank of St. Louis (2010a), p. 12; and also U.S. Census Bureau (2010).
Real retail sales (Figure 1) also took an exceptionally sharp plunge during the recession. For example, in all previous recessions beginning with the 1960–1961 recession, monthly real retail sales compared to a year ago decreased by 8 percent or more for only three months, all in the mini-recession of 1980. By contrast, during the 2007–2009 downturn real retail sales on a year-over-year basis contracted by 8 percent or more for nine consecutive months, ending in May 2009 (Federal Reserve Bank of St. Louis [2010b]). Overall, year-over year retail sales growth was negative for 23 consecutive months ending November 1, 2009. As of April, 2010, real retail and food service sales, seasonally adjusted, stood at $166.886 billion, above its recessionary trough of 158.109 for February 2009, but still well below its local pre-recession peak of $180.290 billion of October 2007.
Figure 1.
The qualitative dimensions of the retail slump can be traced in the broad range of iconic American retailers that succumbed to bankruptcies, liquidations, or massive retrenchments. Chrysler filed Chapter 11 on April 11, 2009 followed by GM on June 1, 2009. KB Toys, one of the largest U.S. toy retailers, sought Chapter 11 protection in December 2008 and announced that it planned to close all of its 460 retail outlets. Circuit City, the second largest electronics retailer in the U.S., declared bankruptcy and closed all of its 575 stores in 2009. Midsize electronics retailer CompUSA closed all of its 103 outlets (although it has since sold its name and 16 of its sites and returned under a new owner). Sharper Image, a leading novelty and electronics retailer, also declared bankruptcy. Linen ‘N Things, the second-largest home goods retailer in the U.S. filed Chapter 11 and liquidated its 371 stores. Fortunoff, a leading jewelry and home furnishing chain in the Northeast, filed for bankruptcy, as did midsize furniture retailers Levitz and Bombay, both of which were liquidated. Many more retail chains scrapped expansion plans and proceeded with massive cuts in the number of their outlets, including Disney (98), Ann Taylor (117), Footlocker (140) and numerous others.See Barbaro (2008), Baertlein (2009), Farfan (2009), Zarrello (2009).
- THE MAINSTREAM CRITIQUE OF ABCT: A CASE OF MISTAKEN IDENTITYAs noted, recently some mainstream economists have criticized a potted version of ABCT that focuses almost exclusively on “forced saving” and corresponding “overinvestment” as the primary, if not the only, distortions occurring during the inflationary boom. The most influential formulation of this version was presented by Haberler (1963) in his survey of business cycle theories published in 1937 under the auspices of the League of Nations. According to Haberler’s interpretation, the boom phase of the cycle is initiated by bank credit expansion in the form of “fiduciary media” or unbacked demand deposits. This results in an increase in the supply of loanable funds beyond the level of voluntary saving. The artificially swollen supply of credit depresses the risk-adjusted interest rate on credit markets below the level of the “natural rate,” which is the rate of return on investment in the structure of production that is consistent with intertemporal consumption preferences. The artificially-depressed loan rate in turn induces additional business borrowing which causes spending on capital or “higher order” goods to increase relative to spending on consumer goods and other “lower order” goods such as direct inputs in the making of consumer goods.
Under conditions of full employment, the diversion of more of the aggregate spending stream from consumer goods’ to capital goods’ industries causes a corresponding change in relative prices that reallocates resources from the former to the latter industries. The expansion of the production of capital goods thus comes at the expense of the production of consumer goods, thereby causing the prices of consumer goods to increase and consumption to be restricted. This phenomenon is known as “forced saving,” because the redirection of resources from consumer goods’ production to capital goods’ production caused by bank credit expansion does not comport with the voluntary saving preferences of households.
The expansionary phase of the cycle comes to an end when the central bank reacts to accelerating consumer price inflation or some other event by significantly restricting its expansion of bank reserves. Credit markets tighten and the risk-adjusted interest rate rises toward its natural level, once again constricting investment to the limits imposed by voluntary saving. The higher interest rates bring the investment boom to a halt. Firms producing capital goods, especially specialized machines, tools and other equipment relatively specific to processes temporally remote from consumers, encounter an unanticipated drop in spending on their output and, consequently, declining prices and profits. At the same time the spending stream directed toward consumer goods continues to swell for a while because previous injections of new money already paid out in wages and rents by capital goods’ producers are transformed into spending on consumer goods only after a lapse of time. As a result, the price of labor continues to be bid up by consumer goods’ firms.
Faced with increasing wage rates and the rising cost of credit, capital goods’ producers can no longer profitably sustain production at current levels. Payrolls and other variable costs are slashed and plant and equipment are idled, as some firms retrench and others shut down altogether. Unemployment rises and the recession sets in.
During the recession, spending on capital goods declines relative to spending on consumer goods. This represents a reversal of the change in relative spending streams that characterized the boom and initiates an adjustment process that re-establishes an optimal pattern of employment for labor and other resources that once again accords with the intertemporal consumption preferences and voluntary saving of market participants. The “structure of production” is thus re-oriented to deliver more consumer goods in the present and near future and fewer in more distant future periods.
It is important to note a salient feature of the foregoing account of ABCT. There are no references to the entrepreneur, monetary calculation, uncertainty or expectations. In Haberler’s formulation, the cycle is driven exclusively by the relative swelling and contracting of current spending streams directed toward different sectors of the economy. The interest rate on loans is merely a mechanism operating directly to enlarge or constrict the channels of these spending flows. Regardless of what causes the change in the interest rate, the effect on the relative spending flows is always symmetrical. Specifically, a fall in the loan rate will enlarge relative spending on capital goods and move resources to higher stage uses from lower stage uses. A rise in the interest rate will have reverse effects on relative spending flows and resource movements.
There are three implications of what we may call this “hydraulic” conception of ABCT. First, the boom involves a shift of labor and other resources out of consumer goods’ into capital goods’ industries, while the recession involves a symmetrical resource shift in the opposite direction. Second, the forced saving and overinvestment of the boom is accompanied by a decline in consumption and shrinkage of the finished consumer goods’ manufacturing, wholesale, and retail sectors as resources are reallocated to the higher stages of production. Third, the recession is characterized by an expansion of consumption as the overinvestment of the boom is revealed and corrected and the temporarily misplaced resources are released back into processes producing goods for consumption in the near future. The new production structure pretty much resembles the old, pre-overinvestment structure, except for some “fixed” capital that may have been sunk in higher stage production processes that had to be abandoned before completion.
Haberler (1963, p. 71) recognized these implications, commenting:
It is a little difficult to understand... why the transition to a more roundabout process of production should be associated with prosperity and the return to a less roundabout process a synonym for depression. Why should not the original inflationary expansion of investment cause as much dislocation in the production of consumers’ goods as the subsequent rise in consumers’ demand is said to cause in the production of investment goods?
Mainstream critics have seized on Haberler’s hydraulic conception of ABCT to dismiss the theory as manifestly inconsistent with the stylized facts of the business cycle. In particular it is observed that, over the business cycle, investment and consumption are positively correlated and the movement of factors back to consumer goods’ industries during the recession is accompanied by substantial unemployment of labor that was absent during the movement of factors to capital goods industries during the boom. Indeed the recent mainstream criticisms of ABCT have been little more than a parroting of Haberler’s original critique in 1937.
Without attribution to Haberler, Paul Krugman repeated this line of criticism in 1998. Dubbing ABCT “the hangover theory,” Krugman (1998) argued:
In the beginning, an investment boom gets out of hand. Maybe excessive money creation or reckless bank lending drives it; maybe it is simply a matter of irrational exuberance on the part of entrepreneurs. Whatever the reason, all that investment leads to the creation of too much capacity.... Here’s the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn’t that mean that they must be deciding to spend more on consumption goods—implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?
Following Krugman’s article, a parade of lesser Keynesian macroeconomists and economist-bloggers weighed in with more or less the same argument. For example, George Mason University economist Tyler Cowen (2008) applauded Krugman’s criticism and added a minor gloss of his own, commenting:
But I think the point is more effective in reverse. Why should the boom be a boom in the first place? The shift toward investment goods, and thus away from consumption goods production, should mean falling real wages, not rising real wages. In other words, the Austrian theory doesn’t generate the very high degree of comovement found in the data. Or, in other words, there aren’t that many countercyclical assets.
As I will argue below, Cowen’s statement perfectly reflects the lack of comprehension of the most potent factor distorting monetary calculation and leading to overconsumption during the boom.
Berkeley macroeconomist and former U.S. Treasury official Brad DeLong (2008) characterized ABCT as a Haberlerian overinvestment theory:
Something—irrational exuberance or fractional reserve banking or loose monetary policy—had pushed the market’s tolerance for risk above “sustainable” levels, the economy had responded by “overinvesting” in capital, and no cure was possible that did not involve a recognition that capital had been overinvested and wasted and that the economy’s capital stock needed to shrink.Note that for DeLong capital investment is limited directly by psychological attitudes towards risk rather than by concrete acts of saving, as if the material resources required for capital formation could be simply conjured out of the ether.
Predictably, Delong’s critique of the theory was remarkably similar to Krugmans’s (and Haberler’s). Argued DeLong (2010):
There is generally no period of high unemployment when resources are transferred out of consumption-producing sectors into investment goods-producing sectors. There is no necessity that the transfer of resources out of investment goods-producing sectors be accompanied by high unemployment. The business of shifting resources between sectors is pretty much orthogonal to the business of maintaining near full-employment and proper capacity utilization.
Australian economist John Quiggin presented a similar objection to ABCT, concluding:
...[U]nless Say’s Law is violated, the Austrian model implies that consumption should be negatively correlated with investment over the business cycle, whereas in fact the opposite is true. To the extent that booms are driven by mistaken beliefs that investments have become more profitable, they are typically characterized by high, not low, consumption.
Lastly, we quote George Mason University economist Bryan Caplan (2008) who gave perhaps the most trenchant critique of hydraulic ABCT:
The Austrian theory also suffers from serious internal inconsistencies. If, as in the Austrian theory, initial consumption/investment preferences “re-assert themselves,” why don’t the consumption goods industries enjoy a huge boom during depressions? After all, if the prices of the capital goods factors are too high, are not the prices of the consumption goods factors too low? Wage workers in capital goods industries are unhappy when old time preferences re-assert themselves. But wage workers in consumer goods industries should be overjoyed. The Austrian theory predicts a decline in employment in some sectors, but an increase in others; thus, it does nothing to explain why unemployment is high during the “bust” and low during the “boom”.... [T]he theory does not predict an increase in employment during the boom, or a decrease during the bust. Moreover, it predicts an actual increase in current output during the bust. These are puzzling implications, to put it mildly, and they follow from the ABC[T].
All of the foregoing critiques are essentially the same in a crucial respect: they are based on a view of ABCT as simply a garden-variety neoclassical theory of sectoral shifts. This is encapsulated in the term “overinvestment” which implies too many resources allocated to the capital goods’ sector and too few to the consumer goods’ sector. Overinvestment always logically implies underconsumption in this two-sector model, whose relative price is the interest rate. This model differs not in the least from a two-commodity, two-country international trade model with increasing costs and incomplete specialization. In this model the imposition of a tariff, say, on wine will distort the relative price between wine and cloth, increasing the relative price of wine and stimulating the movement of resources from cloth to wine in the country importing wine. The relative price and flow of resources will move in the opposite direction in the wine-exporting country. If the tariff is then removed, the result will be a counter-movement of resources out of each country’s import-competing industry into its export sector.
Now let us go a little beyond the comparative static model of undergraduate textbooks and assume: an imperfect degree of labor mobility; a production function for each good that includes inconvertible fixed capital; and static expectations about policy. In this case, there will be a “boom” in the import-competing sector and a “bust” in the export sector of both countries when the tariff is initially imposed. Transitory unemployment will appear and some investment in fixed capital will be lost, but things will go on pretty much as they had before. These effects will be exactly symmetrical in the opposite direction when the tariff is removed.
Note that variations in the money supply are not completely neutral in this trade model despite the fact that there is only one relative price. If we assume that individual value scales are differentiated from one another and that unanticipated injections of new money initially are unevenly distributed to those consumers whose marginal valuations favor wine over cloth, then the price of wine will rise relative to cloth and the same pattern of boom and bust will occur in the two industries that occurred in the tariff case. The effects of unexpectedly halting the monetary injections will correspond to effects of the tariff removal. Thus the Haberlerian-mainstream caricature of ABCT describes a nonmonetary theory of a self-reversing shift of resources between two sectors. The only role played by money is to cause the initial distortion of the single relative price in a two-sector economy. Thus in the hydraulic model, monetary expansion causes precisely the same diversion of spending flows and relative prices as a tariff or many other nonmonetary interventions into the economy. But ABCT was designed to explain the unique distortions created in the real economy and its production structure by an inflationary boom. Indeed, the very essence of ABCT, the falsification of monetary calculation, plays no role whatever in the hydraulic model.
- ABCT: A THEORY OF OVERCONSUMPTION AND MALINVESTMENTHad the critics seriously studied the original sources in which ABCT is expounded, they would have learned that it is not an “overinvestment” theory at all. In fact, Mises, Rothbard and, somewhat less emphatically, Hayek argued explicitly that “overconsumption” and “malinvestment” were the essential features of the inflationary boom. In their view, the divergence between the loan and natural rates of interest caused by bank credit expansion systematically falsifies the monetary calculations of entrepreneurs choosing among investment projects of different durations and in different stages varying in temporal remoteness from consumers. But it also distorts the income and wealth calculations and therefore the consumption/saving choices of the recipients of wages, rents, profits and capital gains. In other words, while the artificially reduced loan rate encourages business firms to overestimate the present and future availability of investible resources and to malinvest in lengthening the structure of production, at the same time it misleads households into a falsely optimistic appraisal of their real income and net worth that stimulates consumption and depresses saving.
Although overconsumption is caused directly by what may be called the “wealth” or “net worth” effect, it is financed by the increase in the money supply and, later in the boom, the drawing down of cash balances as inflationary expectations take hold. On the real side, the increase in the prices and profitability of consumer goods diverts factors from higher stages to consumer goods’ industries, thereby restricting the supply of resources available to add to or even replace the stock of capital goods. This is what Austrian economists call “capital consumption,” which is a pervasive feature of the boom. Far from being the essence of ABCT, overinvestment is thus logically ruled out by it—the boom results in the production of fewer not more capital goods.
Mises (1998, pp. 546–547) vividly described the nature and implications of overconsumption:
It would be a serious blunder to neglect the fact that inflation also generates forces which tend toward capital consumption. One of its consequences is that it falsifies economic calculation and accounting. It produces the phenomenon of imaginary or apparent profits.... If the rise in the prices of stocks and real estate is considered as a gain, the illusion is no less manifest. What make people believe that inflation results in general prosperity are precisely such illusory gains. They feel lucky and become open-handed in spending and enjoying life. They embellish their homes, they build new mansions and patronize the entertainment business. In spending apparent gains, the fanciful result of false reckoning, they are consuming capital. It does not matter who these spenders are. They may be businessmen or stock jobbers. They may be wage earners....
Rothbard (2000, p. 30) also emphatically rejected the overinvestment explanation of ABCT on essentially the same grounds as Mises, referring to it as a “misconception... given currency by Haberler’s famous Prosperity and Depression.” According to Rothbard (2004, p. 993):
Superficially, it seems that credit expansion greatly increases capital, for the new money enters the market as equivalent to new savings for lending. Since the new “bank money” is apparently added to the supply of savings on the credit market, businesses can now borrow at a lower rate of interest; hence inflationary credit expansion seems to offer the ideal escape from time preference, as well as an inexhaustible fount of added capital. Actually, this effect is illusory. On the contrary, inflation reduces saving and investment.... It may even cause large-scale capital consumption.
After discussing the falsification of capital accounting and resulting overstatement of profits caused by inflation, Rothbard (2004, pp. 993–994) concluded
Inflation, therefore, tricks the businessman: it destroys one of his main signposts and leads him to believe that he has gained extra profits when he is just able to replace capital. Hence, he will undoubtedly be tempted to consume out of these profits and thereby unwittingly consume capital as well. Thus, inflation tends at once to repress saving-investment and to cause consumption of capital.
This brings us to the role of forced saving as the source and impetus to overinvestment. As already noted, according to the hydraulic version of ABCT, forced saving occurs during the boom when income is redistributed from those whose marginal valuations of present over future consumption or “time preferences” are higher to those whose time preferences are lower. This will result in an overall increase in saving relative to consumption and therefore in the supply of investible resources in the economy. This forced saving will fuel the overinvestment. Mises rejected this argument for two reasons. First he noted that forced saving is not a necessary outcome of inflation; it is contingent upon the concrete data that shapes a historical inflationary process. Argued Mises,
[O]ne must realize that forced saving can result from inflation, but need not necessarily. It depends on the particular data of each instance of inflation whether or not the rise in wage rates lags behind the rise in commodity prices. A tendency for real wage rates to drop is not an inescapable consequence of a decline in the monetary unit’s purchasing power. It could happen that nominal wage rates rise more or sooner than commodity prices....
Second, and more important, is the point that even when circumstances prevailing at the beginning of an inflation foster forced saving to such an extent that resources are released from consumer goods’ and other lower stage industries, the situation will inevitably be reversed as the boom progresses. Inflationary expectations eventually intensify and become widespread, amplifying the tendency toward overconsumption to the point where it overwhelms the tendency to forced saving. Mises (1998, pp. 555–556) thus concluded:
[W]ith the further progress of the expansionist movement the rise in the prices of the consumers’ goods will outstrip the rise in the prices of the producers’ goods. The rises in wages and salaries and the additional gains of the capitalists, entrepreneurs, and farmers, although a great part of them is merely apparent, intensify the demand for consumers’ goods.... It is customary to describe the boom as overinvestment. However additional investment is only possible to the extent that there is an additional supply of capital goods available. As, apart from forced saving, the boom itself does not result in a restriction but rather in an increase in consumption, it does not procure more capital goods for new investment. The essence of the credit-expansion boom is not overinvestment, but investment in wrong lines, i.e., malinvestment.
Hayek’s conception of forced saving was different from Mises’s, as Roger Garrison (2004) has noted. Mises used the term “forced saving” to denote an actual increase in saving that results when credit expansion redistributes income from workers, typically possessing relatively high time preferences, to capitalist-entrepreneurs, whose time preferences are typically lower. Hayek, in contrast, conceived of forced saving as a pattern of investment that is inconsistent with prevailing time preferences, a situation which, as we shall see below, Mises referred to as “malinvestment.” Nevertheless, despite this terminological difference, Hayek too recognized that both forced saving (malinvestment) and overconsumption characterized the boom.
Hayek argued that a constant rate of forced saving would require an increasing rate of credit expansion in order to allow capitalists to maintain and expand the labor force and complementary factors devoted to producing an elongated capital structure by successfully countering rising bids for these factors by the producers of consumer goods. The continual pressure to expand consumer goods’ production exerts itself through the ever-rising wages paid out in the higher stage industries. These higher wages, which result from the previous injection of new money through credit expansion, appear as increased demand by laborers on consumer goods’ markets after a lapse of time. Prices of consumer goods are thus driven up, approximating the rate of inflation for capital goods after a short lag and causing the wages offered by consumer goods’ producers to rise apace. Now in order to maintain the rate of forced saving constant, i.e., sustain the existing gap between investment and voluntary saving over time, it would be necessary to continually divert additional labor and land factors during successive time periods to the higher stages. As Hayek (2008, p. 319) argued, this requires that credit expansion be renewed at a continually increasing rate. Eventually the increasing rate of price inflation would ignite inflationary expectations, distort monetary calculation and falsify capital accounting, culminating in overconsumption and capital destruction.
Hayek (2008, pp. 320–321) described the forces leading to overconsumption in an appendix to the second edition of Prices and Production published in 1935:
[W]hether the prices of the consumer’ goods will rise faster or slower, all other prices, and particularly the prices of the original factors of production, will rise even faster. It is only a question of time when this general and progressive rise of prices becomes very rapid. My argument is not that such a development is inevitable once a policy of credit expansion is embarked upon, but that it has to be carried to that point if a certain result—a constant rate of forced saving, or maintenance without the help of voluntary saving of capital accumulated by forced saving—is to be achieved.
Once this stage is reached, such a policy will soon begin to defeat its own ends. While the mechanism of forced saving continues to operate, the general rise in prices will make it increasingly difficult, and finally practically impossible, for entrepreneurs to maintain their capital intact. Paper profits will be computed and consumed; the failure to reproduce the existing capital will become quantitatively more and more important, and will finally exceed the additions made by forced saving.The appendix is a response to a critique by Alvin Hansen and H. Tout of the first edition of Prices and Production. Hayek’s analysis of overconsumption does not appear in the original text of the book. This may account for the fact that even Austrian economists have misinterpreted Hayek on this point.
So like Mises and Rothbard, Hayek also believed that overconsumption was a defining characteristic of the boom, although he admittedly did not attribute to it such a prominent role as Mises did.In fact, Hayek published an important but neglected article on “Capital Consumption” in 1932. Although the article discussed the phenomenon in the context of nonmonetary government interventions, Hayek (1984, pp. 156–157, n. 2) recognized the link between capital consumption and the business cycle in a footnote, although at this point he only noted its relevance to “the later stages of a depression.” However, this article was published two years before the article that was included as an appendix to the second edition of Prices and Production cited above. Thus, I cannot completely agree with Roger Garrison (2004, p. 333) when he concludes, “Almost, inexplicably Hayek never gives play to the overconsumption that accompanies credit expansion or even acknowledges the possibility of it.” Garrison (2004, pp. 327–328) also does not quite capture the essence of the overconsumption effect as formulated by Mises when he portrays it mainly as an outcome associated with a policy-induced fall in the interest rate conceived as an incentive to consume more and save less. Mises attributed overconsumption to the distortion of monetary calculation caused by credit expansion, which induces entrepreneurs and households to overestimate their income and net worth. For Mises, the interest rate is much more important in its role as a discount factor than as an inducement to save.Indeed, Mises (1998, p. 525) explicitly denied that the interest rate was an inducement to save: People do not save and accumulate capital because there is interest. Interest is neither the impetus to saving nor the reward or compensation granted for abstaining from consumption. It is the ratio in the mutual valuation of present goods against future goods. As the inflationary boom proceeds, profits begin to regularly exceed even the most optimistic expectations. These “paper profits,” as Hayek calls them, become almost universal, creating a general climate of over-optimism and “irrational exuberance” that undermines shrewd entrepreneurial judgment. Reinforced by inflationary expectations, this results in a growing overestimation of prospective profit streams which, when discounted by the artificially low interest rate, generates fictitious capital gains throughout the structure of production that are completely unhinged from the fundamental realities.
At this point capital accounting becomes a storybook of fantasies and self-delusion rather than a reckoning based on a sober judgment of the future. In addition to the emergence of phantom profits and capital gains, a rapid rise in wages is caused by the attempt of entrepreneurs throughout the production structure to acquire the factors necessary to expand their operations in the later phases of the boom. This wage spiral and the expectations it engenders also fosters overconsumption. The overall result of these inflation-induced distortions of income and wealth is, as Rothbard (2009, p. 793) pointed out, that “the market’s consumption/investment ratio” or time preference is systematically increased, thus driving up the natural rate during the boom. The gap between the natural rate and the policy-distorted interest rate thus widens, causing entrepreneurial miscalculations and malinvestments to proliferate and intensify.
To those critics who object that ABCT implicitly assumes “money illusion” on the part of entrepreneurs, the answer is that in a dynamic economy with a complex capital structure the only method available to entrepreneurs for reliably estimating the outcome of their decisions and investments is monetary calculation. Hayek (2008, p. 321) made this assumption explicit in Prices and Production, writing:
It is important... to remember that the entrepreneur necessarily and inevitably thinks of capital in terms of money, and that, under changing conditions, he has no other way of thinking of its quantity then in value terms, which practically means in terms of money. But even if, for a time, he resists the temptation of paper profits (and experience teaches us that this is extremely unlikely) and computes his costs in terms of some index number, the rate of depreciation has only to become fast enough, and such an expedient will be ineffective.
Now the same calculational distortion that produces overconsumption also concurrently produces the phenomenon of malinvestment. Since the supply of capital goods are diminished by overconsumption, overinvestment cannot conceivably occur. However, to the extent that the newly created bank credit is first obtained by entrepreneurs at reduced interest rates, they have the means and the incentive to expand their operations or to initiate wholly new investment projects whose funding exceeds the available quantity of voluntary savings. The demands and prices for higher stage goods necessary to carry out these investments are increased and there is a corresponding rise in the capital values of firms producing these goods. Resources are diverted into producing new mining and oil drilling equipment, site planning and preparation for new hydroelectric plants, developing computer software for use in designing solar-powered aircraft and so on.The last is not a completely hypothetical example. See Gaudin (2010), Khanduja (2010), Daily Mail Reporter (2010). At the same time, factors are being overused in supplying direct inputs to the manufacturers of finished consumer goods and in more intensively operating their facilities, as well as in constructing and manning additional warehouse and retail space. These malinvestments at both ends create a “hole” in the middle stages of the structure of production, which is “papered” over by profits and capital gains caused by the falsification of monetary calculation.
As the boom continues, firms confront an increasing scarcity of the resources necessary to fully utilize the new mining and oil drilling equipment, to construct the hydroelectric plant and to engineer and mass produce the new generation of aircraft. In a strictly metaphorical sense, then, we may say that the lengthened structure of production cannot be “completed.” The anticipated demands for the products of the higher stage investment projects, even if they are technologically operational, do not materialize because of the greater scarcity and costliness of the complementary labor and capital needed to profitably transform these products into lower order capital goods. At the same time and as part of the same process, other firms lower down in the structure of production that produce raw inputs, spare parts, and equipment for the supply, maintenance and repair of plants and equipment manufacturing finished consumer goods are also incurring rising labor costs, causing them to cut back on capacity.
From the economic point of view, malinvestment and capital consumption cause the structure of production to disintegrate into pieces that cannot be fitted back together again without a protracted recession-adjustment process. During this process both investment and consumption will decline causing unemployment to rise in both sectors. The recession will be further prolonged by the fact that entrepreneurs, after experiencing massive losses and capital write-downs, will temporarily lose confidence both in their ability to forecast future market conditions and in the reliability of monetary calculation. It is this loss of entrepreneurial confidence that is the crux of the so-called “secondary deflation.” Entrepreneurs will increase their demand for money and highly liquid assets and pass up potentially profitable opportunities that they would have seized upon in their normal state of confidence. Thus it is the endogenous factor of entrepreneurial pessimism and skittishness and not the exogenous factor of a contraction of the money supply that brings about the drop in the general scale of prices and, more important, in the prices of the factors of production relative to product prices. It is precisely the rise of the natural interest rate implicit in the relative decline of factor prices that restores the entrepreneurs’ natural optimism and venturesomeness.
In fact, as Mises (1998, pp. 568–569) explained, so-called “secondary deflation” is categorically distinct from a monetary deflation, for it is not the cause of a protracted recession-adjustment period but its essential consequence and cure:
Ignorance manifests itself... in the confusion of deflation and contraction and of the process of readjustment into which every expansionist boom must lead. It depends on the institutional structure of the credit system which created the boom whether or not the crisis brings about a restriction in the amount of fiduciary media…. [E]ven with no restrictions in the supply of money proper and fiduciary media available, the depression brings about a cash-induced tendency toward an increase in the purchasing power of the monetary unit. Every firm is intent upon increasing its cash holdings, and these endeavors affect the ratio between the supply of money... and the demand for money... for cash holding. This may be properly called deflation. But it is a serious blunder to believe that the fall in commodity prices is caused by this striving after greater cash holding. The causation is the other way around. Prices of the factors of production—both material and human—have reached an excessive height in the boom period. They must come down before business can become profitable again. The entrepreneurs enlarge their cash holding because they abstain from buying goods and hiring workers as long as the structure of prices and wages is not adjusted to the real state of the market data. [Emphasis added.]
The effects of the capital irretrievably sunk in unprofitable projects or mistakenly consumed as a part of current income remain even after the recession has liquidated the malinvestments, re-established monetary calculation on a sound footing, and renewed entrepreneurial risk-taking. The reconstructed capital structure will necessarily be shorter and, consequently, labor productivity, real wages and living standards lower. In sum, “The boom squanders through malinvestment scarce factors of production and reduces the stock available through overconsumption; its alleged blessings are paid for by impoverishment” (Mises, 1998, p. 573).
- OVERCONSUMPTION AND THE RETAIL SLUMP, 2002–2009After nearly five years of increasingly rapid growth in the monetary base and the money supply, the Fed throttled back in 1999, triggering the bursting of the dot-com bubble in early 2000 and a recession in early 2001. The Fed reacted almost immediately to these events by aggressively lowering the target Federal Funds rate and reversing the decline in monetary growth. The events of 9/11 led the Fed to ratchet up its expansionary monetary policy. From the beginning of 2001 to the end of 2005, the Fed’s MZM monetary aggregate increased by about $1 billon per week and the M2 aggregate by about $750 million per week. During the same period the monetary base, which is completely controlled by the Fed, increased by about $200 billion, a cumulative increase of 33.3 percent (Figures 2, 3, 4).
Figure 2.
Figure 3.
Figure 4.
The Federal Funds rate was driven down below 2 percent and held there for almost three years, pegged at 1 percent for a year (Figure 5). The result was that the real interest rate, as measured by the difference between the Federal Funds rate and headline CPI, was negative from roughly 2003 to 2005. Rates on 30-year conventional mortgages fell sharply from over 7 percent in 2002 to a low of 5.25 percent in 2003 and, aside from brief upticks in 2003 and again in 2004, fluctuated between 5.5 percent and 6.0 percent until late 2005 (Figure 6). Perhaps, more significantly, 1-year ARM rates plummeted from a high of 7.17 percent in 2000 to a low of 3.74 percent in 2003, rising to 4.1 percent in 2004 and to slightly over 5 percent in 2005. In addition, credit standards were loosened and unconventional mortgages, including interest-only, negative equity, and no-down-payment mortgages, proliferated.For a full explanation of why the monetary expansion affected the housing market first and most intensely, see Woods (2009), Taylor (2009), and Jablecki and Machaj (2009). This caused a rapid expansion of mortgage lending and of subprime mortgage lending in particular, with the subprime share of home mortgages outstanding rising steadily from 8.62 percent in 2000 to 13.51 percent in 2005 (Table 1). As a result of these developments, housing prices once again accelerated to double-digit annual increases after a short and shallow disinflation during the 2001 recession. The housing boom soon turned into a bubble as expectations lost contact with fundamentals and propelled housing prices upward at accelerating rates.
Figure 5.
Figure 6.
Table 1.
Figure 7.
By mid-2003, the credit expansion began to boost corporate profits (Figure 8), and stock prices, stagnant or declining since the bursting of the high tech bubble in 2000, began a steep ascent. While housing prices peaked in 2006, stock prices continued their rise into 2007 (Figures 9, 10).
Figure 8.
Figure 9.
Figure 10.
The sharply rising stock and real estate prices boosted household net worth by over $23 trillion during the three years 2003–2006 (Board of Governors of the Federal Reserve System [2010], p. 107). This drove the ratio of household net worth to annual GDP to well over 450 percent. By comparison, for over forty years, from 1952 until the dot-com boom began in mid-1990s, the household net worth to annual GDP ratio had held between 300 percent and 350 percent. After nearly falling back to this range after the recession of 2001, the Fed’s monetary expansion drove it up by 100 percentage points in a matter of three years (Figure 11).
Figure 11.
This enormous increase in net worth was based almost solely on paper profits and phantom capital gains on households’ real estate and financial assets. Misled by their inflation-bloated balance sheets, households were induced to “cash out” some of their home equity and increase expenditures on consumer goods and services. In the expression of the day, people began “using their homes as ATM machines.” Households financed their increased spending on boats, luxury autos, upscale restaurant meals, pricey vacations etc., through fixed-dollar debt. The increase in value of home equity and 401(k) plans also reduced saving out of current income, and the personal saving rate plunged from over 4 percent immediately after the recession of 2001 to less than 1 percent during 2005 (Figure 12).
Figure 12.
Thus while household assets rose by $21,743.3 trillion from 2003 to 2007, liabilities, mainly home mortgages and consumer credit, increased by $4,500.8 trillion during the same period (Board of Governors of the Federal Reserve System [2010], p. 104). One result of this was that the year-over-year rate of growth of household debt nearly doubled from 6 percent during 1997 to 11 percent for three consecutive years beginning in mid-2003. In addition, debt service payments as a percent of disposable personal income rose from 11 to 12 percent during the late 1990s to peak at 15 percent in 2007. (See Figures 13, 14)
Figure 13.
Figure 14.
When the boom came to an end in 2007, housing prices, corporate profits and the stock market plunged. The capital gains accumulated since the mid-1990s were revealed to be an illusion as household net worth declined by $13 trillion, or 20 percent, during 2008, a figure exceeding the sum of the combined annual GDP of Germany, Japan and the U.K. (Board of Governors of the Federal Reserve System [2010], p. 107). The ratio of household net worth to GDP fell from over 450 percent to less than 350 percent, reaching its 1994 level in early 2009. This brought the overconsumption frenzy, which had spanned two inflationary booms, to a screeching halt. Real retail sales and food services, which had plateaued at an annual rate of $180 billion during 2006 and 2007, declined precipitously to $160 billion in less than a year and remained stagnant for a year. Concurrently, firms in the retail sector shed over 1 million workers from their payrolls with employment dropping from a high of 15.56 million in December 2007 to a low of 14.36 million in December of 2009. On a year-over-year basis, retail employment shrank by 5 percent for more than half of 2009. The S&P Retail Stock Index (RLX) lost over half of its value between February 2007 and November 2009, falling from 533 to 223. Indeed, the fall in the RLX was as sharp and deep as the fall of the S&P 500. (See Figures 1, 15, 16, 17, 18, 19)
Figure 15.
Figure 16.
Figure 17.
Figure 18.
Figure 19.
The extent of capital consumption and malinvestment that resulted from the housing boom is revealed by developments in the Wilshire 5000 Total Market Index (Figure 20). This index tracks the total dollar value of all U.S.-headquartered equity securities with readily available price data. It includes more than 6,000 firms and, as such, it is a good proxy for capital accumulation in the U.S.Fed economists have used the Wilshire 5000 to project changes in household net worth (Blackstone, 2009).
Figure 20.
After reaching a high of $15.5 trillion in 2007, the index collapsed and fell to a low of $8 trillion in early 2009. As I write this, the Wilshire 5000 has been fluctuating around $12 trillion, a level it first reached in 1999. This implies that there has been no net capital accumulation in the U.S. economy since 1999. The capital that has been accumulated since then has either been consumed or wasted in misdirected investments. But it may happen that even the current level of wealth and income is based on false calculations, because the Fed has used every tool at its disposal and has even forged new ones in order to prop up housing and financial asset prices. The weak and tenuous recovery that the U.S. is now experiencing may well be a reflection of the depth of capital consumption and impoverishment that the U.S. economy has suffered as a result of the inflation-targeting policy of the past two decades.
- A NOTE ON “SECONDARY DEFLATION”The ABCT, when correctly formulated, does indeed explain the asymmetry between the boom and bust phases of the business cycle. The malinvestment and overconsumption that occur during the inflationary boom cause a shattering of the production structure that accounts for the pervasive unemployment and impoverishment that is observed during the recession. Before recovery can begin, the production structure must be painstakingly pieced back together again in a new pattern, because the intertemporal preferences of consumers have changed dramatically due to the redistribution and losses of income and wealth incurred during the inflation. This of course takes time.
In addition, the recession-adjustment process is further prolonged by the fact that the boom has wreaked havoc with monetary calculation, the very moorings of the market economy. Entrepreneurs have discovered that their spectacular successes during the boom were merely a prelude to a sudden and profound failure of their forecasts and calculations to be realized. Until they have regained confidence in their forecasting abilities and in the reliability of economic calculation they will be understandably averse to initiating risky ventures even if they appear profitable. But if the market is permitted to work, this entrepreneurial malaise cures itself as the restriction of demand for factors of production drives down wages and other costs of production relative to anticipated product prices. The “natural interest rate,” i.e., the rate of return on investment in the structure of production, thus increases to the point where entrepreneurs are enticed to renew their investment activities and initiate the adjustment process. Success feeds on itself, entrepreneurs’ spirits rise, and the recovery gains momentum.According to ABCT as described above, the typically volatile fluctuations of entrepreneurial confidence and expectations over the business cycle are not purely exogenous psychological phenomena that economic theory must take as given. Rather, they are a rational response to the calculational chaos created by an incoherent monetary regime whose arbitrary manipulation of the interest rate systematically falsifies entrepreneurial estimates of the scarcity of capital. It is important to emphasize this point in order to sharply distinguish ABCT from recent Keynes-like psychologistic theories that seek to explain bubbles, crises and depressions by “animal spirits,” a term which refers to a witch’s brew of various noneconomic motives and irrational behavioral propensities of private economic decisions (see, for example, Akerlof and Shiller [2009]).
The rise in the natural interest rate that overcomes the pandemic demoralization among capitalists and entrepreneurs and sparks the recovery is reflected in the credit markets. For recovery to begin again, there needs to be a steep rise in the “real,” or inflation-adjusted, interest rate observed in financial markets. High interest rates do not stifle the recovery but are the sure sign that the readjustment of relative prices required to realign the production structure with economic reality is proceeding apace. The mislabeled “secondary deflation,” whether or not it is accompanied by an incidental monetary contraction, is thus an integral part of the adjustment process. It is the prerequisite for the renewal of entrepreneurial boldness and the restoration of confidence in monetary calculation. Decisions by banks and capitalist-entrepreneurs to temporarily hold rather than lend or invest a portion of accumulated savings in employing the factors of production and the corresponding rise of the loan and natural rates above some estimated “true” time preference rate does not impede but speeds up the recovery. This implies, of course, that any political attempt to arrest or reverse the decline in factor and asset prices through monetary manipulations or fiscal stimulus programs will retard or derail the recession-adjustment process.
Figure 21.
Figure 21 reveals the extent to which the Fed’s policy response has failed to revive the economy and has prolonged the “secondary deflation.” From August 2008 to June 2010 the Fed more than doubled its balance sheet and M2 increased by more than 10 percent. And yet, during the same period, there was substantial shrinkage of the upper tiers of the U.S. credit triangle, comprising credit extended by nonbank financial institutions and financial markets.The U.S. credit triangle was formulated and calculated by Steve Hanke (2010). Figure 22 shows an updated version of the triangle as of October 2011.This updated representation of the USD credit triangle was constructed for the author by Matt McCaffrey. The author is indebted to Steve Hanke for kindly providing data sources and a description of the methods used to construct the original triangles in Figure 21. Note that two of the three upper layers of the triangle, which are governed primarily by the expectations and decisions of capitalists and entrepreneurs, have continued to shrink despite the fact that the Fed has continued to increase its balance sheet and M2, by 78.9 percent and 11.6 percent respectively. This continuing fall in the credit portion of the triangle goes hand in hand with the weak and tenuous recovery that the U.S. economy is currently undergoing. Both are caused by the failure of the prices of assets, goods and labor services to adjust to economic reality and the concomitant lack of confidence in investment prospects by capitalist-entrepreneurs operating under the extreme relative-price distortion and regime uncertainty imposed by U.S. monetary, fiscal and regulatory policies.
Figure 22.
- CONCLUSIONOnce we understand the ABCT as a theory of the destruction and renewal of both the capital structure and monetary calculation, we are in a position to fully account for the events of the past decade. Furthermore, given the unprecedented monetary interventions by the Fed and the enormous deficits run by the Obama administration, ABCT also explains the precarious nature of the current recovery and the growing probability that the U.S economy is headed for a 1970s-style stagflation.
Volume 14, Number 2; Summer 2011
This short note is a contribution to the solution of the problem of indifference in Austrian economics (“Nozick’s problem”). The problem is divided into two questions: (i) Can the stock of a commodity be defined without a reference to indifference? (ii) What is the praxeological interpretation of the fact that one unit of a homogenous stock is chosen over another? It is argued that the answer to the former question is negative; in the answer to the latter question it is demonstrated that indifference can already be included in the description of choice alternatives and strict preference ordering on the set of these alternatives can thus be preserved.
Volume 4, No. 3 (Fall 2001)According to this writer Garrison’s Time and Money is precisely what it purports to be: an exercise in comparative frameworks. Even if it should be recognized that the comparison of different theoretical traditions within a unified graphical and conceptual—framework may require a number of concessions that are not without drawbacks—in the sense that one or more of the theories thus compared may come out of the exercise more or less mutilated —there can be no doubt that Garrison’s endeavor must be considered a success. The foundation has now been laid not only for renewed and fruitful discussion with different and related schools of thought at the highest level of scholarly debate—an event without its equal since the Hayek-Keynes debate during the first half of the last century—but also for further research along Austrian School lines.
Volume 7, No. 1 (Spring 2004)The Austrian theory of the business or trade cycle is an intricate blend of monetary theory and capital theory. Mises’s (and Hayek’s) monetary and capital theories differ in both significant and subtle ways from the neoclassical approach. Economists working in the Misesean tradition are still plagued by problems of communication with non-Austrian economists. While the terminology used is similar in both theories, the definition of key terms, the understanding of the nature of the economic problem, and the role of prices, especially prices for the means of production, differ considerably.
Volume 4, No. 3 (Fall 2001)Garrison has a vivid sense for the necessity of adequate pedagogy to communicate Austrian ideas about the working of the economy, and he is very conscious of the power of symbols. His book is a great pedagogical effort aimed at replacing the dominant graphical representation of main macroeconomic relationships-the ominous Keynesian Cross-with a new representation, more genuine to the Austrian viewpoint, which stresses the time element in the structure of production. This focus on pedagogical problems has been an old theme in Garrison's work and now finds a consummation in Time and Money. At the book's center stage is an original three-quadrant diagram that is used (a) to illustrate how a market economy works and grows,(b) to illustrate the causes and nature of business cycles, and (c) to discuss and criticize the Keynesian and monetarist paradigms.
Volume 14, No. 4 (Winter 2011)
The 2007–2008 financial crisis, accompanying recession, and continuing slow recovery have reinvigorated crude Keynesianism as the foundation of a "somebody in charge" policy to combat recession and high unemployment. Wapshott "The federal government's urgent response to the financial crisis of 2007–2008, initiated by George W. Bush and continued by Barack Obama, was thoroughly Keynesian, with both administrations intervening in the marketplace to head off the economy's collapse." In his view, "America faced an existential crisis, and as in the 1930s, a failure to act was considered so foolhardy it was barely contemplated." Readers familiar with Rothbard will be aware that it was this urge to action, the State's animal spirits that turned a "garden variety recession" into the Great Depression.
Volume 14, Number 3 (Fall 2011)
Hayek’s writings on business cycle theory; the seminal work of the 1930s and 1940s and the modifications he made in the 1970s after he received the Nobel Prize, are useful starting points for understanding the cycle phenomena in the US between 1995 and the present. Hayek in the 1970s abandoned his earlier condemnation of price stabilization as a goal of monetary policy. In his judgment, such a policy might be the best that could be achieved under existing monetary arrangements, and the misdirection of production resulting from such a policy would be minimal. A careful review of the writings, lectures, and interviews by Hayek in this period show that Hayek did not abandon, but consistently retained the basic elements of his “monetary theory of the trade cycle.” The period clearly exhibits a pattern of production over time consistent with the pattern predictions of Austrian business cycle theory, especially as extended by Garrison (and others). The severity of the recent crisis reinforces Hayek’s call for a significant reform of monetary institutions, a denationalization of money, to better prevent future monetary shock caused boom-busts. The current crisis illustrates that Hayek was premature in his assessment that the effects of money creation intended to keep prices stable [inflation targeting] in a growing economy would have impacts on the structure of production "too small to worry about." Further work, both theoretical and historical, needs to be done to assess his 1970s claim that a monetary authority needs significant discretion in time of crisis to prevent a secondary deflation.
Volume 3, No. 1 (Spring 2000)While damning the free market with the faintest of praise, Krugman’s book provides us with an excellent example of why it is so important to get the analysis right before prescribing policy solutions for an economic problem. In Krugman’s case, bad analysis leads to bad policy recommendations.
Volume 15, No. 2 (Summer 2012)
Jeffrey Friedman and Wladamir Kraus attempt to separate the wheat from the chaff by sizing up these theories next to some hard facts. The result is enlightening. In what is one of the most anticipated books on the crisis, the authors are able to give a logically coherent story and put some tired theories to rest.
Volume 15, No. 3 (Fall 2012)
Monetary disequilibrium theory has some common ground with Austrian economics, but there is substantial disagreement regarding the analysis of business cycles. While monetary disequilibrium theory does include some consideration of the market process so important in Austrian theory, at its core lies a view of equilibrium as essentially a static state. This incorrect definition has led to an inadequate explanation of the business cycle in the monetary disequilibrium tradition. The Austrian theory of the business cycle examines business cycles from within the context of the entire economic process and thus, far from being overly specific, is the only theory that provides a complete explanation of that phenomenon.
Volume 15, Number 4 (Winter 2012)
Austrian business cycle theory (ABCT) has focused on the effect of interest rates set below the natural rate, leading to unwarranted attempts by businessmen to make more elaborate roundabout structures than can be completed by the available foregone consumption. This distorting effect is the main theme of the Austrian capital-based theory of the trade cycle.
But interest rates pushed below the natural rate can have another serious damaging effect. They can distort the appreciation of risk. Austrian economists have claimed that interest rates include a risk premium in addition to valuing future over present consumption. It follows that interest rates below the natural rate can create an unwarranted bullishness that leads to systemic “appraisal optimism.” Error prone “marginal entrepreneurs” receive resources which would not have been available to them in ordinary circumstances.
This mistaken optimism leads to reductions in precautionary assets or “reserve assets” (to use Ludwig Lachmann’s term), which businesses hold against untoward events. The reduction in precautionary assets helps explain how production is possible above the sustainable production frontier (SPF) for lengthy periods during the boom.
The quantity of precautionary assets also explains to what degree businessmen select projects which are risky or time consuming. For any given, the quantity of precautionary assets determines whether businessmen will make more risky or more time consuming investments.
Volume 3, No. 3 (Fall 2000)Free banking is a process where the market makes the ultimate judgment on where to draw the line between money as a present good and money as a future good. Bankers must make a judgment on the proportion of their deposits that represent saving and the proportion that are currently serving as present money for the holders of the deposits. Only funds held as savings may be safely “invested” or loaned. Consumers of banking services make judgments about the safety and soundness of the banking institutions with which they deal. Successful banks will provide the mix of services that meet the needs of their clients. The market test makes it qualitatively difficult to distinguish the Mises from the Selgin outcome. While Mises expected the discipline of the market to move banks closer to the 100-percent-reserve position, Selgin anticipates lower levels of reserves and hence more intermediation and lending. Just as Marshall’s short run blends into the long run, the practical aspects of Mises’s theory of money, credit, and banking blend into the theory of free banking provided by Selgin.
Volume 4, No. 1 (Spring 2001)In this article, the prime concepts are based on the Mises-Hayek theory of the business cycle. Using this model as the general framework for analysis, additions and modifications are introduced reflecting theoretical advances and current problems. Free markets and a strict profit-and-loss system are the best ways to signal erroneous action and induce the constant process of corrective adaptation to bring forth efficiency in the allocation of capital.
Volume 2, No. 1 (Spring 1999)Schumpeter’s business cycle theory is rooted in chapter 6 of the Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle which he published in 1911.[1] This book, which laid the foundations for Schumpeter’s scientific work, did not become famous because of its explanation of the trade cycle. Instead, it was Schumpeter’s analysis of the market process that was regarded as the most important part of the Theory. The point of departure was the traditional notion of an equilibrium economy with goods and money moving in a constant circular flow. Because all of the resources were allocated to their optimal utilization, there was no economic reason to depart from the familiar path. For equilibrium theorists, changes of a given setting could only be triggered by disturbances originating from non-economic events such as wars or natural catastrophes which alter the scarcity conditions of the economy. This would affect relative prices which would force the agents to adapt their plans to the new situation. Once the disturbance had been digested, the economy would assume another stationary state, which would be a stable one because nobody would have a reason to depart from it (Schumpeter 1949b, chap. 1).The problem with this equilibrium notion was that it was not consistent with economic reality. There was no circular flow continuously reproducing itself, and there were not only passive adaptations to exogenous changes of relative prices, but active competition among industrial corporations which introduced new products and new production processes. To include this form of dynamics into economic theory, Schumpeter introduced the concept of the “pioneering entrepreneur,” who breaks away from the equilibrium flow by generating “new combinations” (chap. 2). However, since the equilibrium of an economy is a state in which by definition all assets are employed, neither investment money nor production inputs are readily available to the pioneer. Therefore, the pioneer needs support from the banker who creates credit money. This money can be used to extract physical resources from the circular flow by offering higher prices to the suppliers (Schumpeter 1949b, chap. 3).On the one hand, this procedure creates credit inflation. On the other hand, it enables the pioneer to start a new business. When he finally opens up a new market by offering a new product, he is a monopolist who can charge prices above costs. He starts earning profits from which he starts paying back his credit. The pioneer’s profits signal lucrative investment opportunities to potential competitors who enter the market by imitating the pioneer’s innovation. This increases supply, exerts pressure on prices, and brings profits down accordingly. The process continues until the innovation has spread across the market, profits have been competed away, and repayment of loans has been completed. Finally, the economy reaches a new equilibrium state in which all of the agents have adapted their plans to the new situation (ibid., chaps. 4 and 5).By comparison to the literature of his time, which attributed the causes of economic unrest to economically inexplicable exogenous disturbances, Schumpeter’s theory of the pioneering entrepreneur provided substantive theoretical progress because it modified equilibrium theory by integrating the trigger of economic dynamics. But, the argument presented so far relates only to a single product market. To trace the economic fluctuations of the whole economy back to this elementary source of market dynamics, several additional steps have to be made. The most important one relates to the timing of pioneering moves. If innovation events occurred randomly, distributed over the entire economy, their disturbance effects would not have the potential of generating up- and downswings of the whole economy, because they would average out. In order to gain enough strength to affect macroeconomic totals, the innovation-imitation events have to be synchronized. Schumpeter offers a set of different economic arguments as to why innovations should occur in a swarmlike fashion. First, once the equilibrium has been disturbed by the pioneers, others may follow more easily, because the level of difficulty is lower if the circular flow has been broken already. Thus, primary innovations always induce a much larger number of secondary follow-up actions. Second, the economic and technological effects of innovations are not restricted to the immediate industry that has been affected in the beginning. Instead, they may spread across related industries as well, which in turn are compelled to react. Third, consumption expenditures of employees, whose income has been financed by credit expansion, affect consumption goods industries. Further, reliable calculations of innovative investments can only be made in equilibrium, when economic parameters are known, which requires them to be constant. This is not the case while innovation-imitation processes are going on. Therefore, entrepreneurs having pioneering ideas during a disequilibrium phase of the economy have to wait until a new equilibrium is established before they can break out again (ibid., chap. 6).This is the essence of the first version of Schumpeter’s business cycle theory that was published in 1911. It was elaborated afterwards in a set of follow-up publications. In 1935, Schumpeter worked out the role of equilibrium in his theory. First, he explicitly specified the circular flow to be a Walrasian equilibrium in which each firm and each household are in equilibrium. Second, he laid particular emphasis on the theoretical necessity to start reasoning from a fictitious equilibrium point in order to avoid circularity. Third, he set up the “three-cycle-scheme” which was based on a classification of the innovations according to their economic thrust for generating waves of different lengths. It was made up of Kondratieff waves, Juglar waves, and Kitchin waves having durations of 60 years, 10 years, and 4 years, respectively (Schumpeter 1935).By 1939, the theory had matured and was published in coherent form in a two-volume treatise (Schumpeter 1939).[2] It included the graphical representation of the three-cycle-scheme which had become famous because it explained the Great Depression as the combined result of three coinciding downswings (Schumpeter 1964, p. 175). The largest part of Business Cycles was made up of empirical examinations of American, British, and German time-series on various aspects of cyclical and long-run phenomena, some of which went back as far as 1787 (ibid., chaps. 6–25). Until now, Schumpeter’s work has been the second largest empirical examination of the trade cycle. It is exceeded only by the voluminous studies by Burns and Mitchell (1946) which were made at about the same time at the National Bureau of Economic Research (NBER). The uniqueness of Schumpeter’s work lies in the attention he paid to the history of industries, the behavior of entrepreneurs, and the emergence of new industries, which are not examined by Burns and Mitchell.[3]
Theoretical Problems and Empirical DrawbacksCritics have pointed to several theoretical problems and empirical drawbacks of the treatise. It was argued that the distinction between innovators and imitators exaggerated the case because the latter faced similar obstacles and were also required to have a vision about commercially useful projects. It has been suggested that the unreal stereotypes of the innovator and the imitator be replaced by distinguishing “primary innovators” and “derivative innovators” (Redlich 1955). Further, critics asked why such an outstanding person as the pioneering entrepreneur is supposed to wait until imitators have competed his profits away; he should have both the capability and the means of staying ahead of his rivals by continually producing innovations. The regularity of business cycles called for the rhythmical emergence of pioneering moves which was not guaranteed by Schumpeter’s equilibrium-state argument (Kuznets 1940). First, the idea that reliable calculations were possible only in equilibrium was countered by pointing out that planning of investment projects does not require the complete price list for the whole economy, but is based only on prices for the necessary input factors. Thus, actual information needs are much smaller and can be met at any point in time (Tichy 1984). Second, since finding buyers for a new product is always risky, there is no systematic reason why the risk of introducing an innovation should be higher out of equilibrium (Rothbarth 1942; Tichy 1984). To the contrary, once aggregate profits have started to rise, the very fact that profits can be made is an incentive for competitive moves. Further, the decline of profits during the slump is also a stimulus for change (Rothbarth 1942).Another group of objections was raised against the Kondratieff-Juglar-Kitchin scheme. It was pointed out that there was no necessary connection between the scheme and the theoretical model (Kuznets 1940; Marschak 1940). One objection was that the notion of equilibrium which plays an essential role for the working of the model gets obscured, because the superimposition of three different waves yields eighteen different types of equilibrium. This is due to the fact that points of rest for shorter waves are located on points of unrest of the longer waves. The theoretical consequences of this are not mentioned in the treatise (Tichy 1984). Another objection was that the regularity of each wave’s movement requires the underlying innovations to be of similar economic thrust. But, there is no theoretical reason given in the treatise for why this should be the case (Kuznets 1940). Further, it was emphasized that Schumpeter’s voluminous empirical analysis did not provide much support for his theory (ibid.; Lange 1941; Marschak 1940; Rothbarth 1942). He did not present any mathematical decomposition of historical time-series from waves of different types, but merely recorded his own visual impressions of the charts. His failure to follow the articulated methods of time-series analysis, which had just been developed, was strongly criticized (Kuznets 1940). As a consequence, Schumpeter was not been able to verify his assertion of fixed size-proportion for the three waves (Marschak 1940). The only observation which seemed beyond doubt was his demonstration of the Kondratieff waves. But while his critics accepted this to be a historical fact, they pointed out that there had been no satisfactory theory as to why such long swings should recur as a result of an underlying economic mechanism.
An Outline for a Research ProgramFocusing only on the deficiencies does not do justice to Schumpeter’s work, for Schumpeter himself did not consider his approach to be a complete theory. To the contrary, Schumpeter never tired of stressing that his approach was only an outline for a research program that had to be filled in by followup studies. For instance, in 1933 he criticized the then current practice of the newly founded business-cycle research institutes to focus on aggregative analyses only. Looking at macroeconomic totals was not helpful for the purpose at hand, because aggregates not only blurred historical details but might even provide a wrong picture. Instead, Schumpeter (1933, pp. 265–66) encouraged detailed examinations of the history of industries, which should include single firm studies as well as innovation histories.Further, Schumpeter (p. 266) warned of the uncritical transference to economics of mathematical methods that were not made for this purpose. He suggested that new mathematical methods be developed instead.[4] Two years later, he described a complete research program, which included detailed examinations of the technical, economic and historical features of the development of modern industries to find out more about the influence of internal and external factors on the shape of the cyclical process. Once again, Schumpeter (1935, pp. 8–9) stressed the importance of the study of single firms, because each firm was an individual “resonator.”The strength of the critique raised against the three-cycle-scheme appears to be unjustified, if not even superficial. It does not strike at the heart of Schumpeter’s approach because he never declared it to be an economic law. He frequently pointed out that his intention in setting up the scheme was to get a working hypothesis about the economic impacts of innovations on which the empirical research of Kondratieff, Juglar, Kitchin and others differed. Schumpeter (1935, p. 7) never insisted on three different innovation cycles. He had chosen this number simply for practical purposes to simplify the exposition of the theory. Schumpeter (1961, p. 180) plainly admitted that he had not been able to prove the existence of the Kitchin waves, because he did not have the means for a thorough examination. In the preface of the Business Cycles, Schumpeter (p. 5) invited his readers to do their own research for which his work could provide nothing more than the springboard.[5]
After publication of Business Cycles, Schumpeter continued to stress the advantages that might arise from cooperation between economic historians and theoreticians. He went on publishing essays which were in fact nothing else but outlines for interdisciplinary research programs on the business cycle. For instance, he suggested a classification system for firm-level phenomena. He conducted excellent studies that should be elaborated upon (Schumpeter 1947a, pp. 153–54). He identified issues and problems in order to shape the research process (Schumpeter 1947b, p. 9). He suggested inquiries into the financing of innovations by equity and loans, and the role that the banks played in this process (Schumpeter 1949a, pp. 78–79). Many of his proposals were illustrated by examples from traditional economic theory, which he thought to be irrelevant because they had no grounding in the real world. Again and again, he pointed out the need to examine how individual firms rise and fall and how this dynamic affects the aggregate indicators of an economy (Schumpeter 1947a,b; 1949b; 1951).But all of his suggestions for future work went unnoticed. One reason was that Schumpeter’s theory offered no help for the solution of the economic problems of his time while the theory of Keynes was tailor-made for this purpose. Both its relevance for economic policy and its theoretical compactness explain the victorious advance of Keynesian macroeconomics after World War II. Also, empirical research had not been able to demonstrate the existence of innovation swarms. This was considered to be a refutation of the theory. In today’s textbooks on business cycles, Schumpeter’s theory is presented only for reasons of completeness or is missing altogether.Most surprisingly, the Schumpeterian renaissance triggered numerous studies of innovations, firm behavior, and market dynamics, without considering their implications for the advancement of business-cycle theory.[6] Thus, substantive attempts to improve Schumpeter’s market-process based explanation of industrial fluctuations are still missing. The present article attempts to resurrect this part of Schumpeter’s research program. The following section collects evidence from recent research relevant to the purpose at hand. Particular attention will be paid to findings on the economic heterogeneities of the firm and how this relates to the business cycle. Section 3 then presents a formal model that tries to capture the heterogeneity of the agents by employing spread measures, a new class of variable that has not been used in formal business-cycle theory before. In conclusion, it will be argued that the model employs Schumpeter’s strategy of disaggregate explanation without being open to the criticisms that have been raised against Schumpeter’s approach.
Collecting Scattered Empirical EvidenceIn the present section, three bodies of literature will be examined in order to collect empirical evidence on the functioning of the market process, which might be of use for Schumpeter’s explanation of the business cycle. The first body of literature concerns the innovation problem which has been examined from three different perspectives. The first one is the industrial economic perspective. Industrial economics came into being as a separate branch of economics in the 1950s by doing research into the structure-performance relationship. This approach rested on the implicit assumption that industry market structures were exogenous. In the meantime, scholars have realized that the structure of a market is an endogenous variable that changes systematically over time. From this perspective, the innovation issue is relevant insofar as it determines the development of the market structure via the rates of entry, survival, growth, and exit of firms.[7]The second is research on innovation having its roots in business economics and relates to a wide range of issues centering around marketing policy, reasons for achieving and maintaining market leadership, and the composition of profitable product portfolios. And, the third is research on innovations and stands strongly in the Schumpeterian tradition. It emerged as a coherent body in 1984 when the newly founded Schumpeter Society held the first of a series of semiannual meetings. The literature of the Schumpeterian renaissance combines the two previously mentioned research paths into a consistent theoretical framework. It has encouraged a great deal of work on the measurement and diffusion of innovations, and their impact on the economic performance of firms, industries, and countries.[8]Taken in its entirety, the innovation literature has provided important insights into the working of the competitive process. It has been found that markets pass through different developmental stages as they evolve over time. In the birth phase of a market when a new product has been commercially introduced, considerable experimentation takes place to improve the characteristics of the product. Quite frequently, there is more than one early mover in the market because different firms pursue similar ideas. Entry rates are high because the lead of the incumbents is not wide and entry barriers are low. As the product matures and the dominant design emerges, the nature of competition changes from product-related to process-related innovations. The compulsion to do so arises from within the market, because once the product meets customers’ needs, demand rises rapidly and production has to be increased accordingly.In the expansionary stage of the market, competition for the better product gradually changes to competition for the lower price, which is both an incentive and a force to shift innovative effort to the production sphere. Suppliers who are not able to compete leave the market. As the number of competitors decreases, price competition stiffens because growth of the incumbents facilitates large-scale production techniques which have the side-effect of functioning as entry barriers. These impede imitative entry by smaller rivals and the market matures to an oligopolistic structure. But this does not necessarily mean that the dynamics of competition fade away in the sense of an approximation to an equilibrium, because entry barriers can be circumvented by product differentiation which alters the markets’ boundaries.By comparison to Schumpeter’s time, knowledge of the working of the market process has sharpened substantially. Innovation is not a single outstanding event occurring only at discrete times. Instead, it is an ongoing process affecting products as well as production techniques with an endogenously driven shift of focus toward process innovations. Firms cannot take the liberty of stopping innovation because this runs the risk of falling behind. Further, incumbents cannot prevent their rivals from competing because entry barriers can be sidestepped by product differentiation. Thus, there are both forces and stimuli effective at all times rendering the market process an incessant sequence of competitive moves and counter-moves.What is still missing is the linkage between this industrial-economic research on the dynamics of single markets and the dynamics of the macroeconomic business cycle. But there is not much reason to proceed on the track Schumpeter laid, because innovation research has not provided any clues for the clustering of different primary waves at the same points in time. Neither has there been any evidence for the repeated occurrence of similar wavelengths. Diffusion times have been found to be idiosyncratic properties of the respective markets, depending on peculiar characteristics that are impossible to combine into wave-bundles affecting the whole economy. The shortest diffusion times that have been reliably identified amount to about ten years, suggesting the economy oscillates much slower than it actually does. Innovation research has also found that the economic lifespan of products is competed down in a similar way as prices are forced to decline. This, in turn, would imply an acceleration of industrial fluctuations, which has not been observed.One may conclude from all this that Schumpeter’s explanatory approach does not work, because it has been shown to be not in accordance with the facts. But this would be a hasty judgment. The macroeconomy does fluctuate and this phenomenon is the combined outcome of all businesses in all markets of the economy. Another result might be to say that Schumpeter’s idea of bundling innovation waves according to their frequencies and points of inflection is not an appropriate solution to the aggregation problem. Instead, one might examine firms which are nothing else than bundles of market operations, according to another aggregation criterion. This might provide another view on the emergence of the business cycle which is still within the frame of Schumpeter’s research program. Today, there is not much literature on the cyclical biographies of firms and how their varieties fluctuate, but a few studies exist.The oldest reference of which the author is aware is a paper by Hultgren (1961) published almost fifty years ago. He collected time-series data for corporate profits from 1920 to 1938, which he evaluated using Burns’s and Mitchell’s diffusion index. The indicator revealed a regular pattern of the cyclical diversities of corporate earnings: In the upswings of the economy the number of firms experiencing rising profits went up, but never exceeded 80 percent of the sample. During downswings the number decreased accordingly but never fell short of 20 percent.[9] The numbers indicate that at every point in time there is a subset of firms which moves counter to the majority of the sample population. This subset of firms varies by size and economic weight: The longer an upswing prevails the more firms join the dominant movement of the economy. The same happens during the downswing. Firms are switching between the majority subset of declining firms and the minority subset of expanding firms. Thus, as the cycle moves on, the composition of the aggregate changes in a systematic way. The aggregate’s turning point reflects the fact that the minority process has become the majority process.Hultgren’s paper, which was first presented at a business cycle conference in 1950, has never been cited and has fallen into oblivion, because mainstream economics at his time was predisposed toward Keynesian macroeconomics and had no theoretical use for cyclical variety changes.[10] Hultgren’s method, in a recent article (Schohl 1999a), has been applied to German data and similar patterns have been found for five postwar cycles. Hultgren’s findings were also examined by using a set of different economic variables such as sales, gross production values, and profit rates, all of which behaved in a similar way: At each point in time two polar tendencies are coexistent. There is a majority process which controls the aggregate, and there is a minority process moving in the opposite direction. Firms shift between the two subsets in a cascade-like way. There is one cascade of firms moving from the majority subset to the minority subset. That is, firms pass their individual lower or upper turning points while the economy is still going down or up, respectively. The minority subset increases until it becomes the majority subset taking over control of the aggregate. Stated differently, the occurrence of macro-economic turning points is explained by a population process that starts long before the turning points actually happen.Another piece of empirical evidence that can be utilized to advance Schumpeter’s business cycle theory is a phenomenon called “countercyclical profitability spread,” which has been observed by authors from various countries (Geroski and Machin 1993; Jeger 1994; Lianos and Droucopoulos 1993; Schmalensee 1989; and Schohl and Ipsen 1990). The term relates to the fact that firms are affected unevenly during the business cycle. This unevenness is most pronounced during downswings when the variance of the profit rates or of its changes goes up and reaches its peak at the recession troughs. It has been shown that the increase is caused by a divergence among firms whose profits are declining in a recession and by another group of firms that have passed their individual recession troughs and have started moving up again while the economy is still going down (Schohl 1999b). As has been demonstrated by other authors, the countercyclical spread is caused by a divergence of innovating and non-innovating firms (Geroski and Machin 1993).Putting together the empirical pieces to the puzzle, the following picture emerges. First, there has never been any evidence for the pooling of innovations at certain points in time nor for the similarity of the diffusion times. Product histories were found to be idiosyncratic entities that could not be usefully combined into groups of innovations having a similar economic thrust in the sense of Schumpeter’s Kondratieff-Juglar-Kitchin scheme. Instead, firms are innovative all the time, selling products in all possible developmental stages of their respective lifecycles. Second, as a follow-up effect, the firms’ economic biographies, which are nothing more than the combination of the firms’ product histories in monetary terms, were found to be idiosyncratic as well. But this does not mean that the firm population of an economy is a structureless mass of dissimilar entities. To the contrary, the economic variety of the agents changes systematically over the cycle. These findings related to the countercyclical spread of the profitability dispersion and to the changing composition of the co- and counter-movements of the firms and the macro-cycle. These variety changes are the outcome of the competitive process and provide the point of departure for a disaggregative explanation of the business cycle in which the economic differences of heterogeneous agents play the crucial role.
Theoretical Abstraction: A Formal Model of the Business Cycle Applying Spread Measures OnlyAn Equation System Modeling the Mutual Dependence of Spread VariablesTo set up a formal model of the business cycle that is capable of capturing both Schumpeter’s explanatory approach as well as the empirical observations presented so far, several design decisions have to be made. The first decision concerns the variables of the model. One essential aspect of Schumpeter’s explanatory approach is the demonstration that macrodynamics is the unintended outcome of the firms’ competitive conduct. Therefore, the variables to be selected for the model should reflect the firms’ market operations as well as their market revenues. As has been demonstrated in the previous section, there is empirical evidence on the profitability spread, which varies countercyclically. The spread was measured by using the variance of the annual profitability changes vPC. This variance is suitable for the purpose at hand because it includes both the diversity of the firms’ cyclical fates, and their changes over time. Therefore, vPC is specified to be one of the model variables.The next variable is supposed to capture the diversity of the firms’ competitive market operations. As the innovation literature in the previous section shows, Schumpeter’s approach of considering the rhythmical occurrence of pioneering innovations is not quite in accordance with the facts, because firms are innovative all the time by varying degrees of intensity. A generic variable that comprises the firms’ market operations in their entirety may be called change of market offerings, or offer changes (DOC). OC is supposed to include not only Schumpeter’s core idea of primary innovation, but also all other forms of competitive actions such as secondary innovations and imitations of any kind. It also includes price changes which are an important parameter of action in the later stages of product life cycles, as well as all other forms of shaping offers that are different from before. This comprehensiveness of OC is a formal requirement, because it is supposed to be the explanatory variable for the annual profitability changes (PC), which is also a catch-all variable including economic gains and losses in their totality.The last design decision concerns the specification of the equation system which can be used for modeling the mutual dependencies of the firms’ market-conduct and market-performance variables. From the basic idea of Schumpeter’s theory, it directly follows that equation systems needing an external propulsion for the generation of cycles are not suitable for the purpose at hand. Instead, the essence of Schumpeter’s theory can only be met by equation systems which generate oscillations “from within themselves.” This criterion requires application of the so-called “conservative systems,” which produce non-dampened self-propelling oscillations over time merely from the interaction of the variables involved. The most simple conservative system of equations is the Lotka-Volterra system which is made up of two differential equations for two different variables.The economic considerations for the specification of the equation system are as follows: If a single firm changes its market offerings, this has an effect on its profit rate, which may increase if the innovation is successful, and may decrease if it is not. For the whole population of firms, this means that there is always a variance of offer changes vOC, because the nature of competition is to do things differently to attract potential customers. If the amount of novelty of market offerings differs among the competitors, e.g., if some agents perform pioneering innovations, the variance of the changes of market offerings goes up. If agents are doing similar things, i.e., if imitation prevails, vOC goes down because the amount of product variety is lower than before.Since innovations are usually economically successful or unsuccessful to varying degrees, there is always vOC which is associated with the amount of changes of the variance of the offer changes. In formal notation, this consideration is represented by equation 1, in which vPC is positively dependent on the growth rate of the variance of the offer changes (v'OC):vPC(t) = a1 + b1 · v'OC(t) Equation 1The vPC which has been generated by the above equation, however, affects vOC in a different manner. Firms which have placed new offerings successfully on their respective markets, and have thereby improved their profitability position in relation to their competitors, have no need to proceed with modifications of their offers, because they now start earning money with a new and prosperous product portfolio. These products have left their experimental stage and have moved on to the expansionary phase of the product cycle. The characteristic of this stage is that the main features of the product have emerged. Further modifications are only useful insofar as they gradually continue improvement of its attributes. Therefore, the amounts of offer changes that have widened vOC before, now necessarily have to decrease because the amount of novelty required for economic survival and success is smaller than before. This makes up a negative feedback from vPC to vOC: High growth rates v'PC reduce the variance of the offer changes. Equation 2 represents this economic consideration in formal notation:vOC(t) = a2 - b2 · v'PC(t) Equation 2Equations 1 and 2 constitute a system of Lotka-Volterra differential equations which captures the essence of Schumpeter’s business cycle theory. Its solution, which is the circular curve known from other applications of the Lotka-Volterra model, is presented in figure 1,[11] In order to avoid misunderstandings, it has to be stressed that the present application of the Lotka-Volterra equations is based on completely different economic considerations from previous applications of the model in business-cycle theory.[12] The first and most crucial difference is clear from looking at the variables. By comparison to traditional macroeconomic Lotka-Volterra models that employ sum-total aggregates, the present application employs variances. Thus, the focus is on the heterogeneity of the agents, and not on the value totals for the whole economy. The second crucial difference is that the underlying theoretical considerations are based on competitive market behavior, which is captured by a new type of generic variable: the changes of market offerings. These two differences have important consequences for the interpretation of the model. Figure 1 cannot be understood in the traditional macroeconomic way because it requires thinking in terms of varieties and variety changes. How the phase diagram has to be read economically will be worked out in detail in the following section.
Economic Interpretation of Cyclically Interacting Variety VariablesBefore the economic interpretation of the model can start, two preparatory thoughts are necessary. The first one concerns the location of the cyclical stages in figure 1, which cannot be deduced by mathematical derivation because the equation system does not contain this information. It has to be taken from the empirical evidence mentioned above, which has revealed that vPC reaches its peak at the recession troughs. From this fact it follows immediately that the lower turning point of the business cycle is located at point B. Furthermore, it follows that point D stands for the peaks, and finally, points A and B represent the middle of the downswings and upswings of the economy. Thus, the course of the business cycle is decomposed into four segments: early and late upswing plus early and late downswing.The second preparation for the economic interpretation of the spread model concerns how to read the variables on the two axes of the phase diagram. Formally, both model variables are variances, which are evaluated across the changes of individual values of either offers or profitability. If a variance of this kind changes over time, it indicates that the differences of the individual changes have increased or decreased. The economic interpretation of this nested link of two different changes in one variable can best be explained by first considering vOC, which makes up the y-axis in figure 1.Figure 1The Working of the Spread Model of the Business CycleIn order to survive in competitive markets, firms have to be innovative all of the time. Therefore, offer changes are taking place all the time and, as has been explained in the previous section, the idiosyncrasy of the individual changes of supply widens a variance. The existence of a variance simply reflects the fact that Schumpeterian competition is going on. However, the intensity of competitive conduct not only differs across firms—thereby establishing the variance—but it also differs across time—thereby causing the variance to fluctuate. This is due to the fact that each firm can change the intensity of use of its competitive means if management deems it necessary. Thus, changes of the variance of the offer changes vOC over time come about as the combined result of the variety of the individual changes of competitive conduct, which includes all conceivable forms of primary moves as well as all conceivable forms of competitive countermoves.Two different effects on the variance have to be distinguished. First, if firms change their offers, this provides positive contributions to the variance. As already explained above, the numerical amount of the individual contributions to the variance reflects the degree of novelty that is realized. In any case, current offer changes contribute to an increase of the variance. Second, the effects of past offer changes have to be considered. Firms which have established a new or revised product or have realized any other form of modification of their offerings in the previous period, and do not make any further modifications in the current period, do not contribute to the present value of the variance of offer changes because they supply the same product as before. Keeping supply constant results in a decline of contributions to the variance by comparison to the previous year. This, of course, also happens on the markets all the time: There is no need to change a new product which is sold successfully.Thus, fluctuations of the variance of the offer changes vOC cover the whole set of market actions: changes of supplies contribute spread-shares to the variance thereby raising its value. The decision to stop product changes implies a loss of spread-shares of the respective firms in comparison to the previous period, thereby lowering the value of the variance. The pulsation of the variance which is actually observed in historic time is the combined effect of these two contributing factors. It signals that by comparison to the previous year, one kind of contribution dominates the other one, while both are existent all the time, because the variety of the competitive situations of the individual firms in an economy requires that entrepreneurs apply all sorts of supply-related measures.Similar mechanics applies to the variance on the x-axis of the phase diagram. The vPC widens if large changes of one subgroup of firms produces positive contributions that overcompensate reductions of the alteration amount of the remaining population. It has to be stressed here that profit rates can also be negative. If a negative profit rate changes negatively, i.e., losses increase, this also enlarges the variance because of the square operation in the variance formula.After these preparatory remarks, the emergence of the business cycle from the competitive interactions of heterogeneous firms can be explained by walking around the circle of the phase diagram. Let us first consider the upper half circle D-A-B, which stands for the recession. At point A, the variance of the offer changes is at its peak. The reason for this follows from the history before. Because A represents the middle of the downswing, there are many corporations which have already been hit by the early recession. We know from the analysis of the Hultgren indexes mentioned in section 2 that the firm population is not pulled into the downswing simultaneously, but that the number of firms which are hit by the recession increases incrementally. Therefore, while traversing from D to A, the number of firms that are compelled to change their offerings increases in a stepwise mode as well. The contributions of these firms to the variance of the offer changes increase both by number and by amount, thus making up its rise in the early downswing of the macroeconomy.After passing point A, the variance of the supply changes does not increase further but starts sinking. This is due to the fact that the “early-recession-firms” which have joined into the downswing around D have been working on an improvement of their products since then. These firms have, one after another, finished their innovations and have started selling their improved product offers. If sales increase, it is not useful for this group of firms to make further modifications to their product program, because its renewal has been successful. The contributions of this group of firms to the variance of the offer changes vOC starts to decrease stepwise already between D and A, as the number of firms which have finished their offer changes increases in the course of the recession. Although the overall variance of the supply changes is still increasing between D and A, because of the rising number of firms entering the recession, the countermovement is slowly swelling.After passing point A, the countermovement starts to dominate. While the downswing is still moving on and is approaching the cyclical trough at B, there are still corporations entering into the recession, as the Hultgren index has shown in section 2. These “late-recession firms,” which are forced to change their offerings are making contributions to the variance of the offer, but as the recession has already endured a fairly long run, most of the firms not only have already been affected by a decline of their sales, but they have even finished the renewal of their product program. Thus, the exits from the variance of the supply changes dominate the entries. This explains the decline of vOC between A and B.The driving force of the changes of competitive conduct is made up of the changes of profitability, the variety of which is displayed by the second dispersion variable vPC. From the empirical observations presented in the previous section, we know that vPC increases during the downswing. This is due to two opposite tendencies within the firm population. While firms entering the recession have to accept a decline of their profits or even have to suffer from losses, the value distribution widens downwards. At the very same time, however, firms that have innovated successfully can increase their profits, thereby spreading the value distribution upwards. The combined effect of these two opposite drifts makes up the rise of vPC during the downswing. Or stated in reverse, changes of vPC indicate changes of the frequency distribution of the two divergent effects within the firm population. This inference guides the following analysis of the right half of the figure.The A-B-C segment of the circle is particularly interesting because it includes the lower turning point. From the previous examination, we know that in the late downswing, i.e., while moving from A to B, vOC goes down because the firms one after another finish modernization of their product program, which results in a reduction of their contributions to vOC. At the same time, vPC widens because these firms, the primary movers on their respective markets, realize extra profits by setting themselves apart from their competitors. However, the counterdrift is also working, coincidentally, because the late-recession entrants suffer from losses which also widen the vPC.It is important to keep in mind very clearly that both kinds of drift are not made up of homogeneous blocks of identical agents. Instead, the heterogeneity of the firms and the idiosyncrasies of their market positions and market actions result in some sort of staggering. Firms are hit by the recession at different times with different force, and struggle out of their individual crises at different times by applying different measures. This observation sheds a new light on the lower turning point of the business cycle: At point B, two different cascades are inter-changing. The first cascade is made up of primary movers which have been hit by the recession early, i.e., somewhere between D and A, one after another, and manage to get out of it somewhere between A and B. This cascade of firms gradually raises its individual sales and increases its production activity correspondingly in a stepwise mode. Thus, the cloud of firms starting up their factories begins to swell in the late downswing.However, between A and B this upward drift does not yet affect the direction of change of aggregate production of the macroeconomy, which is still continuing its recessionary path. The prevailing macro-state is determined by the second cascade of firms that are suffering from production reductions at this point in time as has been revealed by analyses of the Hultgren indexes mentioned in section 2. While this cascade of firms makes up the downward course of the aggregate business cycle because it dominates numerically, its downward drift loses power incrementally because firms which are affected by the recession start improving their offers. If the reversals of competitive conducts of the respective firms prove to be successful on the respective markets some time afterwards, it implies a shift of the respective corporations from the descending to the ascending cascade of firms: the recession gradually fades away. Its end is signaled by traditional aggregative macro-indicators if they change direction. In figure 1, this happens at point B. Thus, the characteristic of the lower turning point of the macroeconomic business cycle is simply that at this point in time the cascade of firms expanding their production overrules the cascade of the depressing firms both by number and by numeric weight.After passing B, i.e., after the upswing begins, the features of the firm population continue to transform themselves endogenously. While the first movers have already stepped ahead of their competitors between A and B and have widened vPC, they are now followed by the cascade of the second movers. This can be concluded from the y-axis of figure 1, which displays a decline of the innovativeness of the new offers. The character of competition also changes because imitations now gain increasing weight on the markets. This not only reduces the individual firms’ respective contributions to vOC, as is displayed on the y-axis, but at the same time results in increasing pressure on price, which subsequently reduces the profitability advantages of the early movers. This makes vPC go down, as the model displays on the x-axis.It is important to stress once again that changes of the variance always have to be interpreted as changes of the heterogeneity of the phenomenon under consideration. Thus, it is not allowable to conclude from the decrease of vPC that innovations no longer occur and that firms start waiting until imitating firms have competed their profits away. As the mere existence of the unceasing business cycle already indicates, market dynamics do not come to a halt. Even while traversing from B to C, primary innovations do occur as they do anywhere in the course of the cycle. The present decline of the variance of the profitability changes vPC only reflects the fact that the cascade of the first movers’ profitability advantages, which has widened the variance between A and B, is now narrowed by the cascade of the imitating competitors, which gains increasing weight in the expansionary phase of markets.While competitive pressure on extra profits continues to rise in the course of the upswing and narrows the variance of the profitability changes, this very same pressure stimulates offer changes in order to escape the decay of profits. The need to do so is of increasing importance for the cascade of the first movers, which has widened the profit variance in the late downswing, i.e., between A and B, and has thereby reversed the course of the macro-cycle. This cascade of firms has been working on changes of its offerings in the meantime, and has placed them on their respective markets at those points in time after B, which appeared to be useful for the respective managements.As the upswing proceeds, output of finished, capacity-enlarging factory investments increases supplies on the markets causing the share of firms being affected by a decay of their profits to rises, which in turn implies an increasing need to improve offerings. It follows that there has to be a point in time when the cascade of imitating product changes is overcompensated by the cascade of newly launched product placements by which early movers try to set themselves apart from their competitors. This is precisely what happens after passing C. While competitive pressure continues to rise due to the cascade of finished, expansionary, investment projects, and thereby narrows the spread of profit rates vPC, the variance of the offer changes vOC slowly starts widening again.However, the variance of the profitability changes continues to decline between C and D. This is only because increasing rivalry on markets approaching saturation is still the dominant characteristic of this stage of the business cycle. It is the majority phenomenon which generates the course of the traditional macroeconomic aggregative indicators and—the new observation here—also affects the variance. But from this observation, one cannot conclude that all the firms are suffering from a decline of their profitability. This inference is inhibited quite naturally by the fact that we are analyzing the variance and not the mean of the frequency distribution. Therefore, the heterogeneity issue can never move out of the field of view.Some of those firms that have started offering modified supplies may realize extra revenues immediately, while others may follow at later points in time, because the characteristics of their respective innovation may require some time of diffusion or maturation. Once again, all conceivable forms of idiosyncrasies are present and have to be taken into consideration if the goal of economic analysis is to explain a real-world phenomenon. With the points in time at which the revenues from product innovations start coming in also being a spread phenomenon, the variance of the profitability changes starts increasing when this cascade of market operations has gained enough force to be detected by the variance method of measurement. This happens right after passing point D, at which opposing cascades are changing dominance. Thus, the profitability spread is moving up again, and the variety of the firm population once again has changed its composition endogenously.
Summary and ConclusionBy comparison to Schumpeter’s market-process based theory of the business cycle, several features of the spread model have to be highlighted. First, one of the weakest points of Schumpeter’s approach was the idea that innovations occur in clusters. In the present article, the conception of the innovation “swarm” has been translated to the “variance.” This relaxes Schumpeter’s simultaneity assumption. It is not necessary to defer competitive actions until the economy has attained a point of rest. Entrepreneurs who execute changes of their market offers at any time in the real world are allowed to do so in the model as well. They do not have to wait until competitors have caught up. They may also wait or be too slow and fall behind. Or they may even stop competing and change their field of operation. So at any point in time there is a dispersion of different competitive actions, which is reflected in the spread model by using the “variance” notion.Second, as a followup feature of this modification, the grouping of innovations into different categories of economic thrust is rendered superfluous. The old three-wave scheme is removed completely from the theory. There is no need to decompose the irregular course of a historical time-series into regular components. Instead, the spread-model is based on the idea that macroeconomic time-series are the aggregate outcomes of a multitude of idiosyncratic processes. The only regularity on which the model is based is the empirical fact that there are cyclical changes of the agents’ economic varieties. From this, it directly follows that the spread model does not rely on the equality of the products’ diffusion times and the wave-length of the business cycle. There is no need to link microeconomic and macroeconomic duration variables. Thus, another counterfactual restriction of Schumpeter’s approach is eliminated.Another point of critique that has been raised against Schumpeter’s theoretical setup is his reference to the equilibrium notion, which loses its economic meaning if it is applied to superimposing waves. The spread model is not affected by this logical difficulty because it does not require the assumption of a fictitious stable state for the whole economy. Such an assumption may be a helpful device for an unrelated outside observer who needs a point of reference for his analysis. From an entrepreneur’s point of view, the situation is different because for him it is more important to know how his relative position is affected by his competitive moves or by competitive attacks of his rivals. The spread model captures the different information requirement by locating each firm’s position within the variance of observations and by deriving its dynamics from the positional changes as they are produced by the market process. Thus, the Schumpeterian equilibrium notion has been translated into the firms’ relative positions in the value distribution, which provide idiosyncratic points of reference for idiosyncratic competitive moves of idiosyncratic agents.In this regard, the spread model stands in theoretical contrast to real-business-cycle models that crucially rely on the equilibrium notion. It is the virtue of those models to have demonstrated how the trade cycle phenomenon can be incorporated into equilibrium theory. But this was achieved at the price of heroic and counterfactual assumptions, such as continuous optimization of rationally expecting representative agents. In a world like this, the economic existence of a firm is never endangered by competitive attacks of its rivals because it is removed from RBC theory by applying the representative-firm assumption. By logical necessity, the dynamics of RBC models then have to be imposed from the outside through macroeconomic productivity shocks, the source of which has to remain unexplained. The spread-model avoids all this by permitting the agents to be creative individuals who have to survive in a competitive environment by continually reshaping their market offerings.Another implication of the spread-model relates to the Keynesian downward spiral, which starts spinning if wage payments are cut back. If consumption expenditures decline, investment goes down accordingly. This further accelerates decline of demand which, in turn, induces additional cutbacks of wages. This spiral chain of effects is afflicted with a typical problem of aggregative reasoning: If all of the subjects of an economy are tied to one single macro-agent, there is no endogenous way to stop the spiral. Within this typical Keynesian macro-logic, only the state can help by injecting artificial demand. The spread-model provides no point of attachment for spiral reasoning because there is no representativity assumption that forces the model agents to behave in a similar way. To the contrary: Individual turning points that were observed in reality to happen at any time during the downswing are permitted in the model in a similar way. Thus, the lower turning point of the aggregate is just that point in time at which the upward forces have gained enough strength to overcompensate the downward forces. Within the spread logic, the turning point is an endogenous phenomenon which is generated from within the market system by competitively acting heterogeneous firms. It is not necessary to resort to exogenous factors such as Keynesian state intervention or unexplained RBC technology shocks. The cycle-maker is the market process which generates macroeconomic fluctuations from within the system. In this respect, the spread-model utilizes the explanatory principle of Schumpeter’s market-process based theory of the business cycle without adopting its flaws. Future research should be directed to more profound studies of the variety of the agents’ competitive moves and countermoves in order to fill the model variable “variance of offer changes vOC” with empirical content. Schumpeter’s (1951, p. 155) claim to examine “how firms rise and decline . . . and how this rise and decline affects the aggregates” is still a neglected issue on the profession’s research agenda.
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Simons. 1997. “The Making of an Oligopoly: Firm Survival and Technological Change in the Evolution of the U.S. Tire Industry.” Working paper, presented at the International Conference on Economic Evolution, Learning, and Complexity in Augsburg, Germany.Klepper, Steven, and Elizabeth Graddy. 1990. “The Evolution of New Industries and the Determinants of Market Structure.” Rand Journal of Economics 21, no. 1 (Spring): 27–49.Kuznets, Simon. 1940. Book Review of “Schumpeter’s Business Cycles.” American Economic Review 30, no. 2 (June): 257–71.Lange, Oskar. 1941. “Review of Business Cycles by Joseph A. Schumpeter.” Review of Economic Statistics 23: 190–93.Lianos, Theodore P., and Vassilis Droucopoulos. 1993. “Convergence and Hierarchy of Industrial Profit Rates: The Case of Greek Manufacturing.” Review of Radical Political Economics 25, no. 2 (June): 67–80.Marschak, J. 1940. “Review of Business Cycles by Joseph A. Schumpeter.” Journal of Political Economy 48: 889–94.Oakley, Allen. 1990. Schumpeter’s Theory of Capitalist Motion: A Critical Exposition and Reassessment. Brookfield, Vt.: Edward Elgar.Redlich, Fritz. 1955. Entrepreneurship in the Initial Stages of Industrialization. Weltwirtschaftliches Archiv 75, no. 2: 59–106.Rothbarth, E. 1942. “Review of Business Cycles by Joseph A. Schumpeter.” Economic Journal 52: 223–29.Scherer, Frederic M., and Mark Perlman, eds. 1992. Entrepreneurship, Technological Innovation, and Economic Growth: Studies in the Schumpeterian Tradition. Ann Arbor: University of Michigan Press.Schmalensee, Richard. 1989. “Intra-Industry Profitability Differences in U.S. Manufacturing 1953–1983.” Journal of Industrial Economics 37, no. 4 (June): 337–57.Schohl, Frank. 1999a. “Hultgren’s Cyclical Microdiversity Patterns: A Neglected Class of Stylized Business Cycle Facts.” Jena: Forthcoming.———. 1999b. Countercyclical Profitability Spread: A New Class of Stylized Fact? Jena: Forthcoming.———. 1999c. Die markttheoretische Erklärung der Konjunktur. Jena: Mohr.Schohl, Frank, and Dirk Ipsen. 1990. “Wachstum und Differenzierung: Eine kritische Analyse der Helmstädter-Thesen.” Konjunkturpolitik 36: 3–26.Schumpeter, Joseph A. 1933. “Der Stand und die nächste Zukunft der Konjunkturforschung.” Festschrift für Arthur Spiethoff. Gustav Clausing, ed. Munich. Pp. 263–67.———. 1935. “The Analysis of Economic Change.” Review of Economic Statistics 17, no. 4 (May): 2–10.———. 1939. Business Cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process. New York: McGraw-Hill.———. 1947a. “The Creative Response in Economic History.” Journal of Economic History 7. Supp. (Nov.): 149–59.———. 1947b. “Theoretical Problems of Economic Growth.” Journal of Economic History 7: 1–9. Supp.———. 1949a. “Economic Theory and Entrepreneurial History.” Change and the Entrepreneur. Edited by the Research Center in Entrepreneurial History. Cambridge, Mass.: Harvard University Press. Pp. 63–84.———. [1911] 1949b. The Theory of Economic Development: An Inquiry Into Profits, Capital, Credit, Interest, and the Business Cycle. Cambridge, Mass: Harvard University Press.———. 1951. “The Historical Approach to the Analysis of Business Cycles.” Conference on Business Cycles. New York: National Bureau for Economic Research. Supp. Pp. 149–62.———. 1961. Konjunkturzyklen: Eine theoretische, historische und statistische Analyse des kapitalistischen Prozesses. Göttingen: Vandenhoeck and Ruprecht.———. [1939] 1964. Business Cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process. Abridged with an Introduction by Rendigs Fels. 2 Vols. New York: McGraw-Hill.Shionoya, Yuichi, and Mark Perlman, eds. 1994. Innovation in Technology, Industries, and Institutions. Ann Arbor: University of Michigan Press.Tichy, Gunther. 1984. “Schumpeter’s Business Cycle Theory: Its Importance for Our Time.” Lectures on Schumpeterian Economics. Chr. Seidl, ed. Berlin. Pp. 77–88.———. 1985. “Die endogene Innovation als Triebkraft in Schumpeters Konjunkturtheorie.” IFO-Studien 31, no. 1: 1–27.Utterback, James, and Fernando Suarez. 1993. “Innovation, Competition, and Industry Structure.” Research Policy 22: 1–21.[1] The subsequent exposition is based on a tight selection of Schumpeter’s voluminous publications on business cycles which total about 2,500 pages. For a comprehensive evaluation of Schumpeter’s work see Oakley (1990). The number of pages was counted by Tichy (1985, p. 3).[2] An abridged version was published by Fels in 1964 (Schumpeter 1964).[3] See Schumpeter (1939, chaps. 6, 7, and 14) for many examples of technical innovations from a wide range of industries.[4] In the same year, the Econometric Society was founded with Schumpeter as one of its founding members. For the theme of its journal Econometrica, which included a strong focus on business cycle theory, see Frisch (1933, pp. 1–4).[5] The term “springboard” is used only in the preface to the German edition.[6] A convenient way to get an overview of the typical issues of the rapidly growing literature of the Schumpeter renaissance is provided by the conference volumes of the Schumpeter Society and by its journal, The Journal of Evolutionary Economics. A typical feature of this literature is that it is strongly dominated by industrial economists, whereas macroeconomic issues play only a minor role. Business-cycle theorists have not joined the Schumpeterian community because the current mainstream of neoclassical real business cycle theory is incompatible with Schumpeterian ideas. Thus, the artificial separation of economics into microeconomics and macroeconomics against which Schumpeter fought all his life continues to prevail.[7] See, for example, Klepper and Simons (1997), Utterback and Suarez (1993), Klepper and Graddy (1990), Gort and Klepper (1982) and the references cited therein.[8] See, for example, the conference proceedings of the Schumpeter Society meetings, Hanusch (1988), Heertje and Perlman (1990), Scherer and Perlman (1992), Shionoya and Perlman (1994), Helmstädter and Perlman (1996), and Eliasson et al. (1998).[9] See the chart in Hultgren (1961, p. 328).[10] See, for example, the theoretically helpless comments of Hultgren’s discussant Friend (1951) in the conference volume.[11] For a much more detailed presentation of the model and its mathematical solution, see Schohl (1999c).[12] See, for example, the Goodwin model and the related literature (Goodwin 1967).
Volume 19, Number 1 (Spring 1999)An Interview With Richard K. VedderRichard K. Vedder is professor of economics at Ohio University and an adjunct scholar of the Ludwig von Mises Institute. He is the author of Out of Work: Unemployment and Government in Twentieth-Century America and Poverty, Income Distribution and the Family, and Public Policy (both with Lowell E. Gallaway); The American Economy in Historical Perspective; and articles in The Journal of Economic History and The Review of Austrian Economics. He has taught at the Mises Institute's summer Austrian economics seminar, the Mises University.
AEN: It's obvious that you love teaching.
VEDDER: It's true. I teach everything from introductory economics classes to undergrads, to PhD students. I enjoy working with the advanced knowledge of graduate students, though given the state of economics these days, they sometimes have unlearning they need to do.
But I truly love the enthusiasm of the undergraduates. They start out with little or no understanding of economics. When they leave my class, they know the rudiments. I feel I have made a real contribution to the way they view the world.
AEN: What do you consider to be the rudiments?
VEDDER: I emphasize the all-round meaning and implications of scarcity, and the central place of market mechanisms, primarily property and prices, in dealing with this reality. This is usually considered a microeconomic approach, but you cannot begin to think about my area of macroeconomics without discussing these fundamentals.
Conventional wisdom is that there are two branches of economics, and you can take one without the other, and it doesn't matter which you take first. I disagree with this fundamentally. In Austrian economics, there are not two branches of economics. There is only one theory, applied in different areas. Any Austrian macroeconomist, like Joe Salerno or Roger Garrison, using the same tools, could give a powerful lecture on micro theory at the drop of a hat.
None of the main textbooks stress this point. Not even the market-oriented textbooks concentrate enough on the Austrian point of view for my tastes. I make up for this in my lectures by discussing Mises and Hayek, hoping to spark some interest. Like all professors, I am under constraints, but I try to offer a different perspective nonetheless.
AEN: Do you emphasize the history of economic thought?
VEDDER: Even graduate students are abysmally ignorant of the subject. Most graduate schools do not require the course any more and others have stopped teaching the subject altogether. I consider this terrible. This subject is crucial, unless you think all necessary truth is in the recent literature, which it is not. For this reason, I have volunteered to teach the course next term. I'll be using some of Murray Rothbard's History of Economic Thought.
The greatest insight you gain from the class is that there are a variety of ways to look at economics. It is not enough just to say "here is the neoclassical synthesis" and be done with it. Members of the profession do not agree in a wide range of theoretical and political areas. Realizing this can spark a student's interest. In the typical economics class, you fail to pick up this diversity of thinking.
AEN: What does absence of intellectual history imply about the profession?
VEDDER: History of thought doesn't connect with the agenda of modern mainstream economics. Economics has become extremely technical and narrow in its approach. It has lost sight of broader issues. Many economists have lost sight of how to communicate with students and the general public.
Economists are speaking this specialized language that apes physics and trying to make themselves out to be practitioners of the queen of the social sciences. They want to be seen as smarter and more scientific than sociologists and psychologists. And yet the reality of this approach is to make economics too abstract, and even meaningless in places, dealing with tiny improvements in a small body of theory that has little resemblance to the real world.
Students also get very little basic information about economic structures and institutions. If you ask a typical grad student to describe the operations of the Federal Reserve System most of them will do a pretty poor job of it. Now, I don't love the Fed. In fact, I have argued that we should get rid of it. But a grad student ought not complete a degree in economics without some working knowledge of what it is and how it operates.
AEN: Why would a student study economics if not for a greater understanding of how economies work?
VEDDER: Well, students seem to be going in two directions. There are the standard academic students who aspire to be college professors. They see themselves as theorists and mathematicians who happen to be working with economic phenomena. And there's another group that has a completely different orientation. They want to get their degrees and get out into the business world to make money. Or perhaps they aspire to be like those Nobel Laureates who thought they had discovered the magic formula for investment before their hedge fund nearly went belly-up.
Those two categories sum up nearly all the existing students. But the ones I am interested in do not fit into either category. Those in this third group are interested in economics because they want to discover, from a philosophical and scholarly standpoint, how the world works. They are interested in events, history, institutions, places, law, and policy. They ask probing questions about real phenomena, and seek to understand a general theory to explain it. They care about the history of thought, the workings of central banking, the intersection between economics and other disciplines, and a wide range of real issues.
If you think about it, the truly great economists of the past--Mises being the most impressive example, but also including Hayek, Friedman, and even Keynes and Marx--fit into this third category that is so rare these days. They spoke to the issues of the day.
Most current economists are ill-equipped to do that, because they work only in math and econometrics. They don't know the details of how the world works. They learn the technical material, but don't have a solid grounding in basics, like scarcity and prices.
AEN: This problem undoubtedly affects the way economics is taught.
VEDDER: It is appalling that so many students consider it a dreary subject. Economics can be beautiful. It can be exciting. But emphasis solely on mathematics and technique robs economics of its inherent power. It makes economics dull. I think that explains why more students do not persist in economics.
The American Economic Association established a commission on graduate study several years ago that included economists of all stripes. There was fairly widespread agreement that the profession had become too narrowly technical. For example, it was found that many graduate students couldn't teach a principles class because they were so wrapped up in esoterica.
Most economists today are trained in state universities. They work in state universities or in government. Their income is subsidized, directly or indirectly, by government. There is a pro-state bias built into the system. Most economists have had very little contact in their professional lives with the private sector. They haven't worked in jobs in which consumer service is the priority. They are isolated from the principle and consequences of scarcity.
That would not be a problem if their business was physics, literature, or even history. But economists are writing and thinking about this thing called the economy that they have never actually experienced. That's what accounts for the leftist bias indicated in surveys showing that 80 to 90 percent of economists vote for the Democrats. The growth and popularity of Austrian economics represents a good sign. But still a large majority can be counted on to favor leftist positions.
AEN: Do you think this bias has affected the reception of your own work?
VEDDER: The view advanced in Out of Work is that free markets are the best means to avoid extended periods of high unemployment; prolonged joblessness is most closely associated with a variety of interventionist schemes. This thesis alone guaranteed that we would not get the most respectful hearing within mainstream circles. But we had an additional problem: most of the book is a narrative that tells a story, one that even a lay person can find interesting.
Now, I have probably had more success than most Austrians in reaching the mainstream. I write for mainstream journals and give papers at mainstream conferences. Without compromising, I generally try to approach the discipline in ways that mainstreamers will not find excessively jarring. This is reflected in the book, which includes low-tech regressions. Incidentally, Murray Rothbard loved it. He would always say to me, if you can tell the Austrian story with regressions, go ahead and do it.
The establishment backlash didn't come for a long time. But eventually, we irritated enough Keynesians that it finally came, in the form of an attack from Brad DeLong, a well-known Keynesian at Berkeley. He wrote a slashing attack on the book. Most of his criticisms would be dismissed out of hand by Austrians. Nonetheless, in the new edition of Out of Work, we added 50 pages of econometrics to go along with the descriptive history. We have done even more technical analysis, and it hasn't changed the message one bit. It is still not going to please everyone.
AEN: Can the essential message of your book be conveyed by econometrics alone?
VEDDER: You cannot reduce economics to equations, not even economic history. Ironically, in the course of doing all this math, I have become more and more skeptical of the efficacy of these techniques. There are all kinds of problems with them which cannot be overcome. At the same time, the more I understand about the Austrian literature, the more I marvel at the theoretical sophistication and subtlety of argument you find in the works of Mises and Hayek.
I'm not entirely against econometrics. Neither do I see it as just a way to raise my Nielsen ratings. For all of its imperfections, econometrics can add some rough support for agnostics who cannot see truth through any other means. But you cannot convey ideas like the discovery process in econometrics.
AEN: In fact, you have written a strong critique of relying exclusively on government data sets.
VEDDER: The most popular statistic in economics is the Gross Domestic Product, but the whole thing is problematic. The idea that we can "add up" the national output is fraught with peril in a society in which government is so heavily involved in the economy.
My article with Lowell Gallaway on The Great Depression of 1946 [PDF format] (Review of Austrian Economics, Vol. 5, No. 2) illustrates this. The official statistics at the time we wrote that article (1991) had GDP crashing in 1946, in real terms, by 17 percent. If you believe that statistic, that is the worst year for national output in our nation's history, worse than any year in the 1930s.
And yet, the stock market was rising. Unemployment was low. Ten million people were leaving government employment from the war and entering the job market. The Keynesians were all predicting massive joblessness. It just didn't happen. In fact, there was no Great Depression except in the government's own data sets. Our title was tongue-in-cheek.
The reason is that the government didn't do anything. The soldiers were sent home and that was it. We moved resources from public to private use. We went from a command economy back to a mixed-market economy. And the power of the market reasserted itself after a long time in which it laid dormant during the war.
The official statistics ignore the fact that prices were being controlled in 1945 and 1946, and didn't really reflect real scarcity. Businesses reported the value of goods and services as the price the government paid for those goods and services. Yet no rational human being would pay those prices if they had to purchase them on the market.
After the war, resources were being spent, not on tanks and bombs, but washing machines and cars. Government statistics showed this as a sharp drop in output. But it was total fiction. In fact, this year was a triumph of markets over planning. Ironically, this occurred the very year of the Employment Act of 1946, which enshrined Keynesianism in American life.
The really odd thing is how the numbers keep changing. When the numbers first came out in 1946 and 1947, they said that the economy had fallen 5 or 6 percent. But due to some problems with index numbers that I won't go into, by the early 1990s, the data showed a 17 percent drop for the same period. More recently the data has recorded a 20 percent drop. The government kept revising the figures to suggest it was even a worse depression. Since then, the government has gone to chain-link price indexes, which gets rid of the some of these distortions. The bottom line is that it's all nonsense.
AEN: How much credit does Truman deserve?
VEDDER: Very little or none. In 1946, Truman wanted to keep wage controls on. Congress passed a bill that retained them but not as vigorously as Truman wanted. Truman vetoed it because it didn't go far enough and Congress didn't override the veto. The effect, however, was that wage controls expired statutorily. We went to zero-wage controls, not because of a political commitment to free markets but because of a strategic miscalculation.
Also, when the bomb was dropped and the war was ended, the planners were caught off guard. They had talked about erecting a vast apparatus of peacetime planning after the war. But the war ended so suddenly, they didn't have time to mobilize and put it into place. That was marvelous because it meant that government was not meddling as much as it had been.
Government spending fell more than 70 percent over a two-year period. In fact, if you look at the numbers alone, you might think that Murray Rothbard was president of the United States. He wasn't working on getting rid of government completely, but he was moving in that direction! In fact, the whole thing was a fluke but a very fortunate one for the American economy. We entered into a long period of prosperity. All of this is submerged in American economic history because it isn't obvious from the data, which are highly misleading.
AEN: What other examples of statistical manipulation have you found?
VEDDER: You can support any theory of economics you want to depending on how you manipulate the data. Consider the great controversy over whether we have been richer or poorer since 1973. To support Malthus's position, I could cite data showing the average hourly wage falling 13 percent since 1973, showing that wages are moving toward subsistence. Or I could show that Marx was actually right, by pointing out that output per hour has risen even as wages have fallen. Or I could cite real compensation per hour in the business sector and show wages outpacing profits, which suggests business is being exploited by workers, sort of a reverse Marxism. If you add to this the adjustments made by those who claim the CPI is not being measured properly, matters become even more complicated. You can even show what both neoclassical and Austrian economists would expect: real-wage data and productivity data are moving in the same direction.
I'm not suggesting that the truth is not out there somewhere. I just doubt that government statistics are the magic means for finding it out. Data are highly subject to manipulation. Mainstream economists do this all the time. As Mises warned us, it is a mistake to let the data determine your theory instead of using data to illustrate a principle of economics you can explain through good sense. In pursuing this path, I would say Austrians are more intellectually honest and more straightforward than most mainstreamers.
AEN: Do you worry about what today's students will regard as the economic lessons of the 1990s?
VEDDER: To some extent. I can just see historians of the next decade putting their spin on matters. The 1980s have already been called the Decade of Greed, and that moniker has stuck. I can imagine the 1990s boom being regarded as the consequence of Clinton's mixed economy, while blaming the financial crisis on the Republicans. This is a distortion.
In some ways, of course, Clinton has been better than Bush. Under Clinton, government spending as a percentage of total output has fallen. In 1992, the government spent 22 percent of the GDP. In 1998, the government spent 19.5 percent of the GDP. My interpretation of the prosperity of the 1990s is in this single statistic. The overall size of government fell. (By the way, these numbers may be fundamentally erroneous, but since the distortions occur every year, certain patterns emerge over time that can be useful to examine.)
Clinton's philosophy of government has always been: do whatever is necessary to retain power. The one mark he attempted to make on the country was through his health-care proposal, and he was beaten back pretty badly. When that happened, the stock market was 3,800, about what it was when he took over as president. Since then the stock market has more than doubled.
After the health-care fiasco, the crazies fell out of favor within the administration, and the Republicans took control of Congress. Clinton began to give speeches proclaiming the era of big government to be over. He didn't mean it, of course. But political forces were pushing him in the right direction. The result was a government gridlock, with government growth suddenly lacking that ideological push it needs in order to outpace economic growth. The economy grew at 5 percent and the government at 3 percent, and the result over time has been a relative shrinkage in the government's take.
Two-and-a-half cents of every dollar got taken out of the public sector and put into the private section. This is no revolution but it is a step in the right direction. It provided some impetus for the boom. By the way, the boom is overstated: we haven't had a year of four or more percent of real increases in output. This is the first long-term expansion where this has been the case. Nonetheless, we've been reasonably prosperous, and I think it's been because the big-government liberals have been spooked.
AEN: What about efficiency gains from dramatic technological changes?
VEDDER: Technological changes have always been around. I think the difference may be that the government has been relatively unsuccessful in trying to regulate the new technologies in computers and information. Regulation in some areas has declined. For example, the Interstate Commerce Commission is gone.
The best thing the Republicans did was shut down the government in 1995. The stock market rose three days in a row. I wondered in an article I wrote at the time: since the market went up 100 points with a third of the government shut down, how much would it rise if the whole thing were shut down? In any case, some progress has been made.
I'm not optimistic that this will continue. This notion that we have moved into a free-market age is wildly overstated. The reality is that the forces of interventionism are very much on the march. You can see it in regulatory activity and you can see the political left gaining in Europe. Germany practically has a communist as a foreign minister.
Many of the worst aspects of American regulatory law--for example, the Americans With Disabilities Act--were approved by George Bush, who, I think, was a worse president than Clinton in terms of the economy. There's more to being president, of course. I do think issues of moral turpitude are relevant. Nonetheless, we're talking about economics, and Bush was very bad on that front.
AEN: What do you make of the Commerce Department's data showing historically low savings?
VEDDER: It is true that the rise in equity prices have made people seem wealthier. And there is a well-known rule in economics that people's consumption and income depend not only on their income levels but also on their perceived well-being. If people perceive themselves to be well-off, they feel they don't need to save out of current income.
The way the government defines savings is subject to some debate and scrutiny. Economists usually think of savings as the changes in the flow of wealth minus consumption over a period of time. Well, that's not the way the Commerce Department looks at it. The government says savings is the residual income that isn't consumed. That creates all sorts of inaccuracies. That's why the Fed's superior data diverge sharply from the Commerce Department's.
Again, aggregate statistics have to be handled with care.
AEN: You're not suggesting that the savings decline is entirely artificial.
VEDDER: I think we can still grant that our savings rate is low. I think the main reason is that we tax savings as capital at punitive rates in this country. The double, triple, and quadruple taxing of capital punishes savings because savings is converted into investments and financial capital in the process of creating real physical capital. If you tax capital high, the incentives to save are going to be reduced.
We have corporation income taxes at 35 percent, on top of state income taxes. If the corporation makes $100, $40 are taxed away. Let's say half of the remainder is given to the shareholders in the form of dividends, leaving only $30 to keep as retained earnings to build new machines and expand production. The shareholders will pay a tax of about a third on those earnings. If the shareholder sells the stock, the capital is taxed again.
If you somehow survive all of this with some money intact, you get taxed again if you try to pass wealth on after your death. The federal estate tax table starts at 37 percent and runs as high as 55 percent.
Remember too that some of these gains are mythical because they are brought about through inflation. Let's say your aunt bought $10,000 in stock in 1971. She kept it until 1997, when the stock was now worth $40,000. She then decided to sell it. The government tells her that she made a $30,000 profit, and 20 percent is due to the federal government. After the state government gets its cut, she ends up paying about $7,000 in taxes.
The reality is that because of inflation, the price of everything has quadrupled since 1971. The purchasing power of the initial value is nearly identical to its purchasing power in 1997. There are no real capital gains, and yet she pays the government anyway. Under these conditions, why save? Why not consume?
Many other countries have higher taxes than we do. But they don't have as high taxes on capital as the U.S. does. As a consequence--again granting the problems with this data--most every developed country has higher savings than we do. Until recently, we have saved about a nickel on the dollar. Well, France and Germany save over 12 cents. Italians save 14 cents--three times as much as Americans. Japan and Britain save between 10 and 15 cents. The reason: taxes on capital are very high in the U.S.
AEN: What about indirect taxes on capital and savings?
VEDDER: Certainly, there is the regulatory tax. OSHA regulations require companies to spend billions, not to expand output, but to meet some government mandate. This is a disguised tax. If you add these taxes, you've got something on the level of quintuple taxation on capital. This is gross over-taxation.
Forced savings programs like Social Security end up discouraging savings too. Martin Feldstein, who has limitations, has nonetheless made his reputation demonstrating that this program directly reduces personal savings. The aggregate national savings rate is not increased in the way that people think. I think he is right. There's this fiction that companies don't really pay the Social Security tax, but in fact they do.
The tragedy for younger people is that the money taxed for Social Security is not going to be given back at any respectable rate of return. One solution, that of diverting revenue to higher-return investments, could potentially lead to a government takeover of the stock market. This would be a disaster. The devil is in the details of these plans.
Ideally, I would like to see a total opt-out option: young people surrender their claim to future benefits in exchange for no longer paying the tax. That would eliminate a huge portion of the liabilities in the system. It's possible to do it without a costly transition.
A quick warning: take all predictions about Social Security's future with a grain of salt. If you change assumptions modestly--such as assumptions about the growth in future benefits--the numbers change dramatically. All these calculations you read about in the newspapers are very sensitive.
AEN: To your mind, is there a preferred level of savings?
VEDDER: The Austrian position is that there is not, which is why I am a little uncomfortable with warning about declining savings. Mises and Rothbard were right: there is no optimal level of savings. I believe that Americans save too little, not because I in my wisdom think people ought to save more, but because it is manifestly clear that the government discourages savings, causing them to be below what they otherwise would be.
The optimal rate of savings depends on human action as it operates through the subjective notion of time preference. Whether people want things now or later determines how they allocate their consumption and savings decisions. Part of the idea of the free market is that we allow the price system to signal people to make their own choices. The prices in this case are interest rates, which variously reward and discourage the saving-consumption choice.
This is where Austrians have so much to contribute. A lot of the problems we have in macroeconomics are due to mainstream economists' lack of understanding in this area. When the central bank manipulates the interest rate, it creates distortions very much like those that are created by price controls. The Federal Reserve interferes as much with the market system as a price-control board.
AEN: How does international trade affect economic data?
VEDDER: It causes great difficulties. How can you tell where dollars are earned these days? With economies integrated at all levels within the structure of production, it is hard to know. The Gross Domestic Product statistic measures all output by Americans within a given year, including those living overseas. How do you value what's going on in Japan?
When you consider a company like Daimler Chrysler, you are left to wonder: what nation does this company belong to? Germany or the U.S.? I think the right answer is neither. Corporations are taking on an identity of their own, and part of the reason is that companies are fleeing the tax state as best they can and playing different jurisdictions off each other. They are trying to become transnational. I think all this is wonderful, but it does cause administrative difficulties for corporations.
The great example of skewed data in international economics is the balance of payments data. Within this data, there is something called "errors and omissions," which signals where the bureaucrats couldn't get the numbers to balance out. Well, some years, the errors and omissions reach $50 billion.
Then there is the problem of grey and black markets. I'm not just talking about drug lords in Colombia. This includes people who go to Europe and buy a $10,000 diamond and bring it here in a sock because they don't want to declare it at customs. As the state has grown, we have become a world of liars and thieves. This makes all this data suspect.
AEN: Do you see mergers among international corporations affecting union power?
VEDDER: Internationalization accelerates the decline of labor unions. From a company's perspective, if unions get too strong, it will just move its operations to another region or country. The unions are not really in a position to stop them because union power is seriously on the wane.
In the private sector, union membership is down to about 10 percent of the labor force. That is below the number in 1920, a decade before the Wagner Act and the New Deal and its labor-protection laws. The only argument that could be made for them pointed to the lack of labor mobility in company towns and the like. But now, even the poorest of Americans can afford a jalopy. Anyone can move today, so the notion that a person is "trapped" is absurd.
Americans now realize that we don't need labor unions. However, there is one area where the union thrives, and that is in the public sector. For the first time in U.S. history, one half of union membership is not in the private sector.
AEN: Is your work in labor economics influenced by W.H. Hutt?
VEDDER: He was influential in Out of Work. He once told me that the Depression in the 1930s was in part due to the artificial propping up of wages. I couldn't believe that was true, but as I looked into it, I realized he was exactly right. Murray Rothbard's book America's Great Depression helped me in this regard too. That book was an important precursor to a whole new revisionist school on Herbert Hoover. I think Murray was the first to argue that Hoover was an early New Dealer. Even mainline historians now agree.
Oddly, I never set out to be a labor economist. It was not my focus in graduate school. As I became interested in macroeconomics, I realized that unemployment is a key factor in sorting out the theoretical issues. That's when I read Hutt, as well as Hayek, and the early writings of Edwin Cannan, Lord Beveridge, and Lionel Robbins. They all pointed to the fact that markets are the way to deal with labor problems.
AEN: Labor economics frequently intersects with moral issues, like justice and equality.
VEDDER: I have never understood the appeal of a goal like "equality." People are inherently different. They have different talents, different interests, different degrees of marginal productivity. This is what makes exchange possible. It's what makes life interesting and complex. Variety is the spice of life. Cindy Crawford makes much more money than I do, but I don't resent it. I don't think everyone in the world ought to be forced to look like Richard Vedder.
This obsession with equality is very destructive for the human race. Mises is correct that free societies need to learn to deal with and even celebrate the existence of enormously wealthy individuals. They are a driving force behind rising wealth of the whole society.
By the way, I could give a two-hour lecture on the fallacies inherent in income-equality statistics. In brief, what is the point of taking a snapshot of a one-year period as opposed to a ten-year period? Some people who win the lottery one year are digging ditches the next year. Some people who are college students go from $3,000 to $100,000 per year.
AEN: You seem to have a talent for cutting through the conventional story.
VEDDER: This is what I mean about economics being powerful and interesting. For example, on the Great Depression, there was no need for there to be this decade of mass suffering. It was a consequence of massive government intervention in the economy. This is not just a story of data and number crunching. It is a tragic human drama and ought to be taught that way.
AEN: Certainly the students at our summer program come away from your classes with that feeling.
VEDDER: The great thing about the Mises University is that I feel liberated to teach the way I want to, without fear of reprisal. Like all professors these days, I feel somehow limited in what I can say in my own university, even though I have never been threatened. I have just finished reading The Shadow University, a book by Alan Charles Kors and Harvey A. Silverglate (The Free Press, 1998). I could only read 25 pages per night because it made my blood pressure too high.
What the authors describe is an overall atmosphere on campus of intimidation, brainwashing, political indoctrination, and browbeating, of both students and professors, by an entrenched university bureaucracy. The biggest surprise is how oppressed the students themselves are, with disciplinary boards, dormitory social police, etc. My university is better than most, but even here you worry about taking particular positions on affirmative action and the like.
When I am at the Mises University, I get to say whatever I want to. It has the feel of academic freedom. I go to all those social functions in the evening, and I find it exhilarating. The students want to talk about ideas and concepts. They want to learn. I wish we could have a whole university that operates this way.
Volume 20, Number 1 (Spring 2000)An Interview with Gottfried von Haberler (1900-1995)Taught by Fredrich von Wieser and Ludwig von Mises, and later a professor at Vienna, Gottfried Haberler worked within the milieu of the Austrian School but departed from the theory in important respects. In 1936, Haberler came to Harvard where he exercised a great deal of influence over the American profession.
Haberler's two major works–Theory of International Trade (1936) and Prosperity and Depression (1937)–drew together scattered ideas into a single theoretical treatment. His work on international trade theory placed the theory of comparative advantage within the framework of opportunity cost rather than real cost. His work on business cycles criticized both the Keynesian and Misesian theory. His last article was written for the Austrian Economics Newsletter (Winter 1995).
This interview, never before published, was conducted January 3, 1979, by Richard Ebeling, now Ludwig von Mises Professor of Economics, Hillsdale College, Hillsdale, Michigan, and by Joseph T. Salerno, now professor of economics at the Lubin School of Business at Pace University in New York.
AEN: Professor Haberler, what first sparked your interest in economics?
HABERLER: I must say it was practically by chance. When I entered the university in 1918 they introduced a new degree. Formerly, economics was taught in the faculty of law. I took a law degree, but later on and for practical reasons. But they introduced a new degree for social sciences, Staatswissenchaften, and I got interested in it without really knowing quite what it was.
AEN: With whom did you study while at Vienna?
HABERLER: Oh, in Vienna, primarily with Ludwig von Mises. He was not a tenured professor, as you know. He had the title of professor and was an honorary lecturer Privatdozent, as it was called. But he also had his famous seminar which has been mentioned in the literature, his Privatseminar. Friedrich von Wieser was my first professor, in the sense that I took his course at the univesrity, a big lecture course for hundreds of students. He was a very distinguished gentleman and a fine lecturer. Hayek knew him very well and also studied with him. Later on I studied with Hans Mayer. There were some others; there was Richard von Strigl; he was a little older than me and was part of the next generation after Wieser and Mayer. My closest friends were Fritz Machlup, Hayek, and Oskar Morgenstern. Morgenstern, Hayek and I later became lecturers, Privatdozent, and we had a joint seminar after we took our degrees.
AEN: How did you originally meet Professor Hayek?
HABERLER: Oh, I met him in the university. He was a year ahead of me, but we met regularly in Mises's private seminar, which was held every other Friday, and that went on for years and years. Mises also taught in the University and gave a course there. It was there that we met for the first time. Hayek was in fact closer to Mises than myself. But, in the end, we were all together in the Mises-Kreis [the Mises-Circle]. Morgenstern and Machlup were of course members of the seminar as well.
AEN: How did you find Professor Mises as an instructor?
HABERLER: He was excellent; first class. Both in the university where he was very popular and then in his famous private seminar.
AEN: What kind of topics were discussed in his private seminar?
HABERLER: Everything. Monetary theory, of course, but also a lot of time was spent on methodology. Yes, methodological problems and the sociology of Max Weber, that struck a cord in our minds. It was very much the a type of methodological subjectivism. And I have noticed that Ludwig Lachmann mentions that he also got interested in Weber. The sociology and philosophy of Weber was discussed very much. And in Mises' seminar, there were not only economists but lawyers, and philosophers, such as Felix Kaufmann. By the way, he was a versifier. One of his poems is reprinted in a Mt. Pelerin publication in 1961 honoring Mises's 80th birthday. It was a very nice little poem about Mises's private seminar. Unfortunately, it was never translated. Kaufmann was a philosopher, but he was also interested in economics. So the group was a mix of people interested in philosophy, economics and sociology.
AEN: What kinds of contributions did those seminar participants make, for example, Strigl or Ewald Schams or Paul N. Rosenstein-Rodan?
HABERLER: Schams was a mathematical economist, and a bridge to the Lausanne School. Rosenstein-Rodan also was interested in mathematical economics and the Paretian School, i.e., general equilibrium economics. We all got along very well. There was no such sharp division between Austrian economics and mathematical economics.
AEN: I understand that Professor Strigl also make contributions in both methodology and trade cycle theory.
HABERLER: Yes, he wrote a book called Economic Categories. I believe the title in German is Die Okonomischen Katagorien und die Organisation der Wirtschaft. Most of the people there had practical positions. Mises, of course, was a secretary of the Chamber of Commerce. Strigl was also in some government office. I, too, was in the Chamber of Commerce for years. Mises had gotten me a job there, first in the library and later I was engaged in trade policy problems. Hayek had a job in the Chamber of Commerce building, though not with the Chamber itself. Hayek's job was in an office engaged in settling prewar liabilities and assets. Mises and Hayek worked together there. There were several other people who also had jobs. You may have heard the name Helene Lieser, though she didn't write very much; she had a job in the Austrian Association of Bankers. Morgenstern later joined Hayek in the Institute for Business Cycle Research--the Austrian Institut fur Konjunkturforschung, as it was called. Now it is called the Institute for Economic Research. It was one of the first business cycle institutes in central Europe.
AEN: What motivated Mises and Hayek to found the institute in 1926?
HABERLER: Well, Mises had developed his theory of the business cycle and Hayek's first publications were in that area. Hayek published his theory of the business cycle in 1931 in his book,Prices and Production. Hayek had based it on the earlier writings of Mises, Knut Wicksell and Eugen von Böhm-Bawerk. At first, I was very much interested in the approach but then I moved away from it; I am now closer to the Chicago School than to the Austrian School.
AEN: What led you question the relevance of Hayekian business cycle theory?
HABERLER: I realized that you can't explain a deep depression by real maladjustments emphasized by Mises and Hayek. It was the so-called "secondary deflation" which made the Great Depression so bad, and not any enormous real maladjustments. I think Hayek would agree with that now. You may remember that we published at AEI a little pamphlet, A Discussion with Friedrich von Hayek (1975), where I tried to get him to admit that it was the secondary deflation which made the Great Depression such a disaster rather than large real maladjustments, and I think Hayek would now agree with that. He said it in so many words in that publication.
AEN: Did Wilhem R?pke have any influence in this respect?
HABERLER: R?pke was not, of course, a member of Mises-Kreis, but we all knew him and later on I saw him a great deal after I moved to Geneva. He came occasionally to Vienna. He was close to us as far as free-market policy was concerned, but on understanding the secondary deflation, he was ahead of the Austrians. Also, Albert Hahn, a German banker, was a personal friend of Mises's and a personal friend of us all. Hahn and R?pke stressed the secondary deflation, and I think they were right. Their ideas were formulated independently of the Chicago School, which came much later.
AEN: Do you think, though, that the Mises-Hayek analysis has relevance at least in explaining the primary distortions?
HABERLER: Well, that may be so, but the particular type of maladjustment that Hayek has in mind, I believe, is not really a very important factor - what he calls the "vertical" maladjustments in the structure of production. What impresses me is that on other occasions our economy handles very large maladjustments, as, for example, during a transitions from war to peace and from peace to war, without much trouble. But in Hayek's theory those so-called vertical maladjustments are supposed to bring about the enormous disaster of the Great Depression. To my mind, that makes no sense.
AEN: The focus of both Mises's and Hayek's approaches was on the non-neutrality of money. The way money is injected into the economic system tends to effect the structure of relative prices and, by affecting relative prices, tends to influence the allocation of resources along alternative productive uses.
HABERLER: Yes, there certainly is something in that. If you inject the money into the economy one place rather than another it makes a difference. The monetarists try to handle that problem by saying that in the second and third rounds of spending, say, after a year or so, it doesn't make too much difference where the new money had been injected. I have an open mind on this question, but on the whole, I tend to agree with the monetarists that it really doesn't make too much difference. But it does make some difference.
AEN: What do you think originally accounted for the wide popularity of Hayek's theory at first, and then for a decline of interest in it?
HABERLER: Well, there was the Great Depression, and Hayek said he had an explanation for it. Later on, of course, it was overshadowed by the rise of Keynesianism. And John Maynard Keynes in some sense was right, namely, that once you had a deep depression a purely monetary policy to prevent a further deflation is not enough. Milton Friedman himself says there is such a thing as a cumulative process.
I like to quote that from the very end of his Monetary History of the United States. He makes the point that the rock which starts the landslide can be easily held back, but once the landslide is underway, you need a stronger force. I would apply that to the Keynesian policies in the Great Depression. Once it has become cumulative then easy money, even a zero rate of interest, doesn't help very quickly. Particularly if a deflation has been going on and prices have been falling, you would need to have a negative rate of interest, and that, of course, is not possible.
Therefore, in such a situation, I think Keynes was right. Injecting money directly into the income stream by a budget deficit was required to stop the landslide. I think this argument applies against the monetarists, as well as against Mises and Hayek. Terrace Hutchison, in his pamphlet Keynes versus the Keynesians (1977), published by the Institute of Economic Affairs, makes the point that Hayek, Lionel Robbins, Arnold Plant, and T. E. Gregory wrote a famous letter that appeared in the London Times on October 19, 1932, in which they rejected deficit spending. That I think was a great mistake, as Robbins later acknowledged.
I don't know what Hayek would say if you asked him now. Maybe he would admit it, too. In any case, the letter was very damaging and was probably responsible to some extent for the success of Keynesian theory. In that particular situation the Keynesian prescription made sense that what was needed was large deficit spending. But the mistake the Keynesians now make is that they go on speaking as if they still lived in a Keynesian world with mass unemployment, where you can spend without raising prices. That, of course, is nonsense. That is the weakness of the present Keynesian school, that they still think they are living in a deep depression, which is simply not true. Right now, we are very close to full employment, despite an unemployment rate of six percent.
AEN: If there had not been wage rigidities during the Great Depression, would you still have recommended that an active fiscal policy was needed to get us out, or could the market have adjusted on its own?
HABERLER: I recommend deficit spending only in a big depression and not in a mild recession. In a mild recession, of course, we have the "automatic stabilizers." You need not go out of your way in a mild recession to create a government budget deficit. It comes about all by itself through the existence of a large public sector, so there is really not much need to reduce taxes. Taxes, of course, should be reduced, they are altogether too high in general. But as an anti-cyclical device, I think, manipulating the tax rate is not necessary unless you get into a really bad recession. And the last recession, our recession of 1973-75, was, of course, a recession and not a depression in the sense of the Great Depression or earlier depressions. It was a mild affair.
AEN: One of the analytical methods that the Keynesians use is emphasis on aggregates, i.e., looking at the general wage and the general price levels. I understand that in the late 1920s you wrote a book on index numbers, Der Sinn der Indexzahlen (The Meaning of Index Numbers). What was the essence of your argument in that book?
HABERLER: Well, that was a technical book on index numbers, and I tried to link up the index number problem with general economic theory, but it did not have much on the particular problem to which you are referring. Now, I hear that Keynesians are criticized for using aggregates. I think that everybody uses aggregates.
Of course, you can overdo it. You can make the aggregates too large, but the economy is simply too complicated to go all the way down in a practical way to the last minute microeconomic distinctions. So I think that criticism of the aggregate approach has been overdone. It is a matter of degree and not either-or. But if you ask me, the weakness of Keynesian theory is that they overlook or have never learned to distinguish between the money rate of interest and the real rate of interest. That of course goes back to Irving Fisher. Probably you can trace it back further if you look. But we in Austria were always aware of that distinction.
I did mention in my book on index numbers that it is possible that the price level changes differently for different classes of goods and consumers, but here you have the practical problem that you cannot easily handle such fine distinction. You would not, however want to say that index numbers are useless because you would need an infinite number of index numbers to incorporate all the microeconomic distinctions. That I definitely did not mean to say in my book.
AEN: You mentioned that you thought there was some truth to the Keynesian argument in a deep depression. What were your first impressions of the General Theory?
HABERLER: Well, I never wrote a review of the book, but in the second edition of my Prosperity and Depression, I added a chapter on Keynesian theory. The first edition only made reference to Keynes's book in footnotes because the General Theory appeared when my book was almost finished.
I was impressed on the whole, but I criticized the multiplier theory and called it, as Keynes puts it, a tautological theory and not very useful. He didn't distinguish between the instantaneous multiplier and the serial multiplier. There were mistakes of that sort, but still it was a very stimulating book. Now, I remember Hayek criticized Keynes's Treatise on Money, published in 1930. I don’t remember if he wrote a criticism of the General Theory, but I think Hayek's review criticizing Treatise was very good. He had a published exchange of views at the time with Keynes. But personally they were on good terms. Hayek knew Keynes quite well, and they often talked to each other. Keynes said some very nice things about the Hayek's Road to Serfdom. And in one instance Keynes said that Hayek's argument in The Road to Serfdom was good medicine, but a bad diet.
AEN: Did you ever have the opportunity to meet Lord Keynes?
HABERLER: Oh, yes, very much so. He invited me to Cambridge for a month in 1932. I was his guest in Kings College and I talked in his famous seminar where no blackboard was permitted.
AEN: They say that he had a very charismatic personality. Did you find that to be the case?
HABERLER: Oh, he was a most interesting man and an excellent speaker, very quick, and so on. Charismatic? I don't know whether that is the right word. He didn't impress me in that way, but he certainly impressed his followers in that manner.
AEN: One of the major criticisms you made of Keynes's book in Prosperity and Depression was what later became known as the Pigou Effect. What drew your attention to this internal problem with his system?
HABERLER: It was not Arthur C.Pigou who drew my attention to it; I came across Pigou's argument only later. It made simply no sense to me to say that, if wages and prices were perfectly flexible, they could go down indefinitely with nothing happening to money. It seemed to me that the quantity of money in real terms would rise indefinitely and that this would bring about reflation; Keynes overlooked this.
But what I would stress more now, in an inflationary situation, is what I said earlier about the distinction between the real rate and the money rate of interest. This has never been incorporated into Keynesian theory, and even now Keynesians overlook it when they say the interest rate is very high. Nevertheless, when you look at the inflation rate, you see that the real interest rate is very low. This is a basic mistake that they made.
AEN: Did Keynes ever comment to you about your criticisms?
HABERLER: No, he did not.
AEN: If one goes through the reviews that were initially written of the General Theory, most were either critical or skeptical of various parts of his approach, yet within a short time a great many in the economics profession accepted Keynes's general argument. What accounts for this?
HABERLER: Well, that it was a "general theory" presented in manageable terms, by which I mean in terms of large aggregates. Keynes's theory easily lended itself to diagrammatic, mathematical and econometric treatment; at the same time Simon Kuznets developed the national income accounts approach and these two develops were soon merged together.
AEN: What do you think of the reinterpretation of Keynes offered by Robert Clower and Axel Leijonhufvud?
HABERLER: Well, in one sense I think they are right, for Keynes himself would not be a Keynesian today. You may remember Hayek reporting that in his last days Keynes had said that, yes, his followers had gone too far, but that he would turn around public opinion. He realized that in the new inflationary situation, his prescriptions were no good. Clower and Leijonhufvud tried to make allowance for that and to interpret the original Keynesian theory in the light of the new situation where the old prescriptions don't work.
It happens very often, you know, that the founder of a school finds himself in conflict with his followers. Marx wrote to Engels on one occasion that he, Marx, was I am not a Marxist! Keynes came close to saying that in his posthumous article on “The Balance of Payments of the United States (Economic Journal, June 1946). He spoke of some of the prescriptions of his followers as modernistic stuff gone silly and sour. That type of comment was aimed at Richard Kahn, and I sometimes feel that we should have Leijonhufvud write an article on Friedmanian Economics and the Economics of Friedman, because the rational expectations people also go a little bit too far. Friedman does not go that far. He is much more reasonable than the rational expectations people, so there is a similar type of conflict arising between the founder of this school and some of his extreme followers.
AEN: What so you see as the fundamental problem with the rational Expectations literature?
HABERLER: Oh, they go much too far. They are saying, for instance, that monetary policy cannot have any effect because people immediately anticipate it; that, when they read in the paper that the money supply has gone up, everyone concludes that the price level is going up, and everyone takes immediate actions which make the effect nugatory. So they, in effect, assume that everybody is an accomplished econometrician, and a one hundred percent monetarist, which I think is simply not so.
AEN: In his reinterpretation of Keynes, Leijonhufvud also laid stress on the idea that what Keynes was really talking about is his theory of "involuntary unemployment" was the problem of imperfect knowledge in a decentralized market. What are your thoughts on that interpretation?
HABERLER: There, I don't think they are right. This is the modern theory of the microfoundations of monetary and inflation theory. I am all for microfoundations, but that particular type I again think goes too far. Leijonhufvud and James Tobin propose, as an amendment to Keynes, that workers are not concerned with their absolute wage, but with their relative wage. If they see that somebody else gets more than they do, they ask for a higher wage, even if it means that they remain unemployed. That makes no sense to me. Workers do not always know what their fellows are getting. It certainly doesn't apply to the mass unemployment which existed in the 1930s. People had no jobs. This new interpretation of Keynes–that what is more relevant is whether someone in a similar position is better off–is, I think, quite unrealistic.
AEN: Do you think that a good part of the unemployment of the 1930s was due to wage rigidities?
HABERLER: Yes, of course. Pigou took the same position, but said it did not mean that he would recommend deflating the economy to increase the real money stock through flexible wages and prices. If you are in such a situation, then you have to manipulate demand, and in such an extreme depression you have to manipulate it, as I said before, by injecting money directly into the income stream, rather than by relying on the Pigou effect. What Hayek, Plant and Robbins in were really recommending in their London Times letter of 1932 (though they didn't put it in those words) was to rely on the Pigou effect to bring the economy back into balance, and I think that was very unrealistic.
AEN: What is the history behind your writing of Prosperity and Depression?
HABERLER: I was asked by the League of Nations to come to Geneva. They had a grant from the Rockefeller Foundation to start work on business cycles. They wanted a work reviewing business cycle theories to see which points various theories had in common, which theories were relevant, and whether a synthesis was possible. That's what I tried to do.
AEN: What are your views on the monetary approach to the balance of payments, which has recently come out of Chicago?
HABERLER: I don't know whether you saw it, but I wrote a review of a book by Harry Johnson on that topic was a little critical of it. I was sorry my good friend, Harry, was very unhappy with that review. My feeling was that it was half-baked; they were very unjust toward what they called the elasticity approach and the absorption approach, and that they all can be put together in one baggage. The elasticity approach is not without its merits. But I said all I have to say in that review in the Journal of Economic Literature, vol. XIV, no. 4 (December 1976), pp. 1324-1328).
AEN: Do you see the monetary approach as basically the classical approach to the balance of payments?
HABERLER: That's what they said, that it all started with David Hume. Jacob Frenkel from Chicago wrote a book on the history of the monetary approach to the balance of payments in which he mentions almost every economist who wrote on that subject between Hume and Harry Johnson as having contributed to the monetary approach. I think that shows that it isn't so novel.
And it is also probably my Austrian background and the inflationary experience we all went through in the 1920s. That made us a little more sensitive to inflation and the distinction between the real and money rate of interest, and the role of inflation in influencing the exchange rate, and the foreign exchange market. The American and British economists who had not had this experience with high inflation were, perhaps, a little handicapped, a little slower in catching on to the inflation problem.
AEN: How would you assess our most recent experience with freely floating exchange rates?
HABERLER: Floating exchange rates came about because fixed exchange rates cannot work in a milieu of high inflation. The basic fact is that if you have high inflation of the major countries, those countries cannot agree on a common rate of inflation of, say, ten percent. There are those countries which simply don't go along, and you get the inflation differential between Germany, Switzerland and Japan, on the one hand, and the United States on the other. That accounts for the decline of the dollar and for the fact that Bretton Woods has been replaced by floating rates. Of course, there are about forty countries that still peg their currencies to the dollar, and there are a few currencies which are pegged to the Mark. But the major currencies all float because of the large inflation differential.
AEN: Do you think floating exchange rates have prevented the spread of the inflation virus from on part of the world economy to another?
HABERLER: Yes, I think so. Otherwise German, Swiss and Japanese inflation rates could not have gone down, for example the Swiss to zero, the German to two percent, and the Japanese to three and a half percent. With fixed rates they would have had to follow the dollar, so in that sense it has prevented the spread of inflation to a few countries–only a few, unfortunately–who have managed to bring their inflation rate down.
AEN: What do you recommend as a long run solution to our international monetary problems?
HABERLER: The most important thing is for the United States to bring its inflation rate down. After all the United States looms very large in the world economy and the dollar is still the foremost international reserve and transactions currency. Therefore, we should bring our inflation rate down at least to the German level; if we could do that, then the remaining imbalances or reemerging imbalances could be handled by minor fluctuations in the exchange rate.
AEN: But you would not be for going back to fixed exchange rates?
HABERLER: This is simply impossible, because, not everybody is ready for it. If the major countries come down to a lower inflation rate, then the exchange rates will stabilize all by themselves. But it puts the cart before the horse to say first: "Let's go back to fixed exchange rates," and assume that everybody will behave.
After all, we tried that; we had the Bretton Woods system and it broke down because not everybody behaved. That situation has not changed. For that same reason, I am rather skeptical about the new European monetary system. The Germans are now down to a two percent inflation rate; the Italians are over ten percent. I simply cannot understand how can you stabilize their currencies with these inflation rates.
The Italians are supposed to get the margin of six percent, but if they have ten percent inflation, six is not enough. That can work only if the Germans underwrite the inflation of France, Italy, Denmark and Ireland. And perhaps the British will also come in if the Germans are willing to underwrite them.
AEN: How relevant is the purchasing power parity theory in explaining the current decline in the dollar or the foreign exchange market?
HABERLER: There is certainly a connection with the purchasing power theory. The price levels between different countries cannot diverge indefinitely. It's not a very precise instrument, but roughly speaking the movements in the exchange rates do reflect their respective inflation rates. Sometimes it's magnified, and especially today with the large dollar balances. The diversification of these balances when the dollar shows signs of going down all the time, may push the dollar temporarily below the equilibrium rate, but basically I think the exchange rates are determined by inflation rates.
But there are different indices, you know; you can take the GNP deflator, the CPI, or the index of manufactured goods and this gives you different results. It's not a very precise instrument. But as the purchasing power parity theory demonstrates there are connections between the price levels of different countries and their exchange rates. There is no doubt that the purchasing power parity theory is useful.
AEN: Do you see any difference between the standard version which comes from the Swedish economist, Gustav Cassel, and the version of the purchasing power parity theory developed by Mises which does not focus on price indices?
HABERLER: Mises didn't like terms "price level" and so on, and as a result I thought he got into difficulties. Yes, as you say, he basically had the same theory as Cassell, but then he said that it was not possible to speak of "price levels" or use to index numbers, and I saw a contradiction in this. You can put it in terms of the methodology of subjectivism, and go down to small aggregates, or ideally to individuals, and reject the aggregative approach, but that I think is practically impossible. You can't handle such complicated problems by going down really to the last individual unit. The economy is too complicated for that; you have to use aggregates.
AEN: What do you see as the main causes and consequences of the current worldwide stagflation?
HABERLER: The main cause is that we have gotten too far from a system of competitive capitalism. In a really competitive economy, one that would be much more competitive than ours as far as prices and wages are concerned, there would be no stagflation. Stagflation, i.e., ?the combination of high unemployment and rising prices, is possible only if you have rigid wages and, therefore, also rigid prices. So stagflation is not due to a basic defect of the capitalist free enterprise economy, but, on the contrary, to the fact that we have gotten too far away from the ideal of the competitive economy.
AEN: You have criticized the ideal of the notion of perfect competition as the main criterion in formulation anti-monopoly policy. What are the conditions of a workable competition? How much control of monopoly should there be?
HABERLER: Well, this is a big question. I have not done much work on that. In my mind the basic problem is in the labor field. Money wages have become completely rigid downward in practically all countries. Further, real wages have become completely rigid downward through indexation and so on. Apart from the labor field, the situation is not too bad.
The growth of international trade is the postwar period has introduced much more flexibility. If we just think of the United States, we have three or four automobile firms. That would be an ideal case of oligopoly, but with all the competition that comes from Europe and Japan, and now even from less developed countries, the economy has really become more competitive.
So to my mind it is mostly the labor field, and then also, of course, from government policies. Governments, one the one hand, make wages rigid by helping the unions in various ways, minimum wages and so on, for example; also among the main culprits are government regulation and protectionism.
AEN: What policies would you recommend to cure the current stagflation?
HABERLER: To curb the power of unions and reduce government regulation. The best anti-monopoly policy is free trade. We are very far away from that and are getting even farther away from it.
AEN: What are the reasons behind the repeated calls for wage and price controls? We've had bad experiences with them, and yet people still call for them.
HABERLER: They have never worked, and yet, despite that, they have been tried again and again. Nobody wants to go back to a more flexible, competitive system. So people think they can do it artificially by working on the symptoms, rather than on the causes. Democracy has its drawbacks, but many of the dictatorships are not doing much better.
Volume 1, No. 3 (Fall 1998)This very ambitious book starts with the high promise of a radically new and superior theory of business cycles, but when it ends the reader cannot resist the conclusion that the promise has gone unfulfilled. Tyler Cowen states his goal quite explicitly. He finds the “traditional” or “old” Austrian theory of business cycles (hereinafter ABC) to be inadequate and outmoded. Nevertheless, Cowen sees merit in certain aspects of ABC, such as capital goods’ complementarity and the importance of intertemporal coordination. Therefore, he offers a “new” Austrian approach whose elements include rational expectations, real business cycle theory, and sectoral shifts, and whose organizing motif is the role of risk in entrepreneurial decision-making. This alternative, risk-based theory of business cycles (hereinafter RBBC) is presented by Cowen as a sophisticated and improved version of the “naive” ABC. It is the result of “grafting rational expectations and modern finance theory onto the original Austrian theory” (p. 10). If such a procedure sounds unsavory and unlovely, I can assure the reader that the resulting amalgam is little better.The book is divided into five chapters. The first is an introduction in which Cowen names the deficiency he is trying to improve upon: “the traditional Austrian approach fails to establish its central contention—the link between positive rates of nominal money growth and excessive capital-intensity” (p. 2). He then defines what he means by investments that are risky. These are “long-term, costly to reverse, high-yielding, and having returns highly sensitive to the arrival of future information” (p. 3). Mai investments occur when “entrepreneurs earn less than the risk-free (or minimum-risk) rate of return” (p. 7). Cowen further stipulates under what assumptions his RBBC will be developed. They include expectations that are rational in the sense that errors are serially uncorrelated (although he rejects the idea of strictly homogeneous information), constant returns to scale, perfect competition in all sectors, and perfectly flexible wage rates and prices. He even reveals a capsule version of one of the key conclusions to be found in later chapters.That is, contrary to ABC, inflation does not systematically lead to unsustainable malinvestments and a boom-and-bust cycle. Sometimes monetary policy produces sustainable expansions; “the final outcome is never certain in advance” (p. 4).Chapter 2 is devoted to a discussion of RBBC in real terms, as opposed to nominal or monetary terms. Here Cowen claims that his approach represents a kind of middle ground between ABC, which interprets cycles as driven by entrepreneurial errors, and so-called real business cycle theories, which insist that cycles are driven by technology shocks. The common thread, per Cowen, is the reaction to risk on the part of entrepreneurs. The extent to which investment is undertaken can be affected either by exogenous events such as unexpected changes in a central bank’s monetary policy or by endogenous events such as credit rationing, shocks to retained earnings, the arrival of new information, or sudden shifts in entrepreneurs’ preferences regarding risk exposure. When discussing the latter, he even utilizes Keynes’s notion of “animal spirits” (p. 25). The list of possible precipitating factors is quite long. Indeed, when reading this chapter, I got the unsettling impression that to Cowen’s mind virtually anything can bring about a business cycle.There are at least two assertions in Chapter 2 that are sure to rankle most Austrians. First, Cowen confirms quite candidly what a reader will quickly come to suspect. That is, RBBC sees business cycles, at least in part, as evidence of market failure, not merely as an aberration imposed on an unsuspecting economy by an intrusive central bank. With RBBC, “all business downturns indicate a market failure, even if the government causes the relevant negative shock” (p. 15). Second, focusing on Hayek’s work on cycles, he claims that ABC fails to address the issue of “comovement,” that is, the observed general expansions or contractions of activity across many sectors of the economy. Apparently Cowen interprets ABC as dealing exclusively with the shifting of resources from consumer goods production to capital goods production, or vice versa. Thus he questions how such intersectoral resource movements can lead to the phases of the business cycle.Chapter 3 elaborates further on this RBBC, primarily in the context of two basic monetary scenarios. The first is an increase in the rate of growth of the monetary base that lowers real interest rates and thus precipitates a typical boom-and-bust cycle. The second is an increase in “monetary uncertainty or volatility” that throws the economy into a recession without first experiencing an expansionary period. According to Cowen, the former occurs unambiguously only if such monetary growth does not also involve an increase in volatility. If it does not, then entrepreneurs will be induced to invest in longer-term, more capital-intensive, and thus allegedly riskier, projects. Since these are highly sensitive to new information, some entrepreneurs’ expectations will be foiled as time passes, and these projects will prove unprofitable. Bust follows boom. In the latter scenario, monetary volatility rises, but presumably not the average rate of monetary growth. This discourages investment in longer-term projects, because it increases perceived risk; growth rates decline; and the economy descends into a recession without a preliminary expansion.What about the very plausible case in which the rate of monetary growth both rises and becomes more unpredictable? In RBBC, the result is indeterminate, because two opposing forces are at work. “The net effect will be uncertain, and long-term investment may either contract or expand” (p. 46).This chapter also presents Cowen’s views on some of the issues surrounding (a) credit rationing, (b) alternatives to discretionary monetary policy, and (c) the non-neutrality of money with respect to capital markets. If creditors respond to changes in monetary policy by varying the quantity of funds loaned, but not necessarily the rate of interest charged, then the basic, positive relation between money and investment probably still holds. Ceteris paribus, monetary growth encourages investment and tends to increase the cyclicality of the economy.Regarding monetary rules, Cowen finds none to be a simple solution to business cycles. He assumes throughout that the key relationship is between the monetary base (rather than some broader monetary aggregate) and business investment. Any regime that includes a central bank allows for the possibility of monetary base manipulation. Thus, he concludes that price-level rules, nominal GNP targeting, nominal interest rate targeting, commodity currencies, and even 100-percent-reserve banking all may fail in a central banking context. Does this then imply that free banking, with gold as the base money, must be the answer? No, according to Cowen, because even though free banking exhibits automatic restrictions on overexpansion of the (inside) money supply, it does “not necessarily stabilize the marginal cost of producing gold” (p. 57).Although he gives lip service to both Ricardian equivalence and the Modigliani-Miller theorems concerning monetary policies that do not involve fiscal changes (pp. 68–70), Cowen nevertheless agrees with Austrians and other economists who insist that changes in monetary policy are not neutral with respect to real economic variables. “[W]e should think of monetary policy as a real sectoral shock, rather than as a purely nominal event” (p. 64). However, when discussing whether long-term interest rates as well as short-term rates will be affected by a given change in monetary conditions, he once again hedges his bets. Everything “depends on expectations” (p. 74) in that investment decisions may hinge on whether the change in short-term rates is expected to be temporary or permanent.Chapter 4 will probably garner more attention from Austrians than any of the other portions of this book. It is here that Cowen describes, analyzes, and strongly criticizes what he takes to be the traditional Austrian explanation of business cycles. He portrays ABC as an approach that “views investment as the transmission mechanism for the cycle, starts with the assumption of full employment, links the monetary and real sectors of the economy, uses a loanable funds theory of interest, and builds on Wicksellian themes” (p. 76). The representative expositors of ABC he apparently takes to be Mises, Hayek, Rothbard, and Garrison (pp. 10, 76). Although Cowen is critical of several prominent features of ABC, the one feature with which he is most preoccupied is the posited expectations of entrepreneurs.Cowen argues that ABC assumes both that entrepreneurs mistake monetary inflation for an increase in voluntary savings and that entrepreneurs mistakenly think that the observed decline in real interest rates will prove to be more or less “permanent.” He rejects both as implausible. Indeed, he offers eight detailed reasons why he thinks they should be rejected (pp. 80–100). These include the assertions that private savings do not exhibit the volatility implied by ABC, constant nominal money growth may make newly undertaken investments sustainable in the long term, current real interest rates do not provide reliable information about future commodity demand, and lower real interest rates may be the result of a decline in loanable funds demand rather than an increase in the supply of loanable funds. The two signal extraction problems associated with ABC he then contrasts with a third type in which economic agents fail to distinguish nominal price effects from real price effects. This last type he correctly identifies as being central to the models of certain New Classical theorists such as Robert Lucas (p. 79).Cowen’s assessment is that the “Austrian theory does not follow directly from the ability of inflation to distort market price signals, or from the injection of new inflationary funds into the loanable funds market” (p. 101). His own, risk-based, approach allegedly avoids the implausible assumptions of ABC and thus offers a superior theory at the same time that it exhibits a degree of eclecticism which brings it closer to neo-Keynesians, modern monetarists, and real business cycle theorists (pp. 2, 104).Chapter 5 is composed entirely of a survey of recent econometric work on various aspects of business cycles and related monetary issues. The chapter does not, contrary to what one might suppose, present Cowen’s testing of some formal model of his own creation. The studies that he catalogues are so diverse, and the results so mixed, that they are quite difficult to summarize. However, in very rough form, Cowen finds at least some support for the propositions that (a) money growth does affect real interest rates and brings about intersectoral resource shifts, (b) changes in uncertainty affect aggregate investment, (c) capital-intensive industries often experience greater cyclicality than other industries, and (d) monetary inflation can increase the riskiness of bank loans. Does any of this unambiguously imply the superiority of either ABC or RBBC? No. And amazingly enough, Cowen admits it. “None of these results, however, discriminates decisively in favor of risk-based (or traditional Austrian) theories as opposed to other potential business cycle mechanisms” (p. 149).
A Good Effort Gone WrongThis book possesses some virtues. The subject of business cycles is certainly important enough to justify a book-length treatment, and I would give Cowen high marks for a brave assault on a difficult topic. His risk-based approach, although I believe it to be fatally flawed, is innovative and challenging. Moreover, unlike most economists, he treats the traditional Austrian theory with seriousness and attempts to grapple with its principal features. In addition, it is clear that Cowen is familiar with a wide range of research on business cycles and on certain related issues in monetary and capital theory.On the other hand, this work is disfigured by a number of errors and deficiencies. These might be categorized under the two broad headings of (a) problems of content and (b) problems of style or exposition.Allow me to begin with the content of the book. Most fundamentally, Cowen argues that ABC, though not without some merit, suffers from certain mistakes that his RBBC avoids. Therefore, RBBC is supposedly superior. But does Cowen accurately portray ABC? No, he does not. I will give just a few of the more glaring misstatements to be found in the book (there are more). Cowen repeatedly states that ABC focuses on low real rates of interest that are brought about by positive rates of monetary growth. In fact, ABC focuses not merely on historically low rates of interest, but on rates that are lower than the natural rate (Mises 1966, pp. 558–59; Rothbard 1970, pp. 862–63; Garrison 1989, p. 22). It is that inconsistency between the rate in the market for loanable funds and the (natural) rate which reflects individuals’ time preferences which lies at the heart of ABC.Moreover, it is not just any monetary increase that can precipitate a cycle per ABC, but only that which involves an expansion of credit in the form of new business loans (Rothbard 1978, p. 152). If Cowen had kept this in mind, it might have prevented him from wondering why ABC assumes that a lower market interest rate must be the result of an increase in the supply of funds rather than a decrease in the demand for funds (pp. 85 and 101). Of course, remembering that time preferences have not changed would also help in this regard, but then Cowen dismisses the concept of time preference (along with the natural rate of interest, the Ricardo effect, and forced savings) as worthless (pp. 65, n. 11, 95, 105–8).Cowen declares that ABC offers no explanation for “comovement,” the expansions and contractions of both capital goods and consumer goods. That is simply false. ABC explicitly argues that, as interest rate signals induce entrepreneurs to invest in a more roundabout production process, capital goods production “booms” and persons involved in capital goods industries enjoy higher incomes. Since time preferences have not changed, those increased incomes will predominantly be spent for consumer goods; therefore the demand for, and the quantity supplied of, consumer goods will rise. In short, dollar expenditures for both capital goods and consumer goods will rise, though not strictly simultaneously. Eventually, the rising costs of production reveal that many of the projects which have been undertaken are, in truth, unprofitable, and the recession ensues. Incomes fall in capital goods industries, and this spills over into reduced demand for, and quantity supplied of, consumer goods (Mises 1966, pp. 552–54; Rothbard 1970, pp. 854–59). Contrary to Cowen, ABC offers a lucid and temporally sophisticated explanation of why both the general expansion and the general contraction occur.In addition, Cowen portrays ABC as starting from the assumption of full employment in the economy (p. 76). According to Rothbard, this is a common criticism of ABC, but nevertheless incorrect. Credit expansions always generate cyclical effects “whether or not there are unemployed factors” (Rothbard 1970, p. 866).Even setting aside the abovementioned misunderstandings of ABC, this book still has problems. Perhaps the most fundamental of them all is the very use of the concept “risk.” It is not entirely clear what Cowen has in mind. On the one hand, he wants quite badly to link RBBC to certain features of modern finance theory such as mean-variance analysis and the capital asset pricing model (CAPM). There, risk refers to the variance of the probability distribution of past returns on some existing asset. It involves historical data and is quantifiable. On the other hand, he insists that his primary concern is with the entrepreneurial choice of whether to invest in new long-term or new short-term projects. In that case, whatever project is selected will represent a unique event, and there are no historical data upon which to draw. Strictly speaking, no probabilities can be calculated (Mises 1966, pp. 106–16). Here, the entrepreneur faces uncertainty rather than risk. Is it possible that Cowen is unaware of this potentially critical distinction?It is also troubling that Cowen assumes longer-term projects are necessarily “riskier” than shorter-term projects. He does grant the possibility that the reverse could, in theory, sometimes be the case, but rejects it as “the exception” (p. 23, n. 5). Of course, this assumption is essential to RBBC, because without it there would be no systematic way to connect “risk-taking” to the capital structure. A similar difficulty arises with the possibility that some entrepreneurs may, under some conditions, be “risk-seekers” rather than being unfailingly “risk-averse.”One would even be justified in asking if RBBC really represents a theory of cycles at all. I say that because the text is peppered with statements of the form, “If X increases, Y might either increase or decrease.” Perhaps that is why no formal model is offered: Cowen could not unambiguously specify the algebraic signs of the parameters involved.Finally, the assumption of rational expectations as an integral part of RBBC must be called into question. Cowen admits that this assumption does not accurately describe the real world, but retains it anyway based on the belief that it is “a useful form of discipline” (p. 8). I would have thought that reality was the most useful of all forms of discipline; but Cowen prefers to assume rational expectations, because he believes this assumption forces the analyst to specify the “explicit informational asymmetry” that leads to entrepreneurial errors (p. 8). Odd that Cowen later castigates Austrians for being overly specific about the informational asymmetry between entrepreneurs and the central bank regarding those credit expansions which bring about the boom and bust cycle (pp. 80–82).I will be mercifully brief with my comments about the writing style encountered in this book. Such mercy is motivated by the fact that, with reluctance, I must admit that the writing is rather uniformly awful. Far too much of the book reads like a series of “laundry-lists.” There are eight reasons for rejecting ABC, six assumptions of RBBC, eight stylized facts about cycles, thirteen postulates of ABC, seven empirical questions involving cycles, and so forth. The presentation is often clumsy and pedantic; there is no grace or elegance of exposition. Some will say that is excusable in an academic and technical work, but I still prefer economists who can write.It is difficult to imagine that the audience for this book will be large. Austrians will quarrel with Cowen’s basic premise that ABC is decidedly deficient and needs to be replaced. Monetarists, New Classicals, neo-Keynesians, and real business cycle theorists will probably be disappointed by the absence of any formal models. Only the few who are particularly keen to read everything available on business cycles are likely to struggle through this book.
ReferencesGarrison, Roger W. 1989. “The Austrian Theory of the Business Cycle in the Light of Modern Macroeconomics.” Review of Austrian Economics 3: 3–29.Mises, Ludwig von. [1949] 1966. Human Action: A Treatise on Economics. 3rd rev. ed. Chicago: Henry Regnery.Rothbard, Murray N. [1962] 1993. Man, Economy, and State: A Treatise on Economic Principles. Auburn, Ala.: Ludwig von Mises Institute.———. 1978. “Austrian Definitions of the Supply of Money.” In New Directions in Austrian Economics. Louis M. Spadaro, ed. Pp. 143–56. Kansas City: Sheed Andrews and McMeel.
Volume 19, Number 3 (Fall 1999)An Interview with Frank ShostakFrank Shostak is chief economist at Ord Minnett Jardine Fleming, Sydney, Australia, one of the largest brokerage houses in that country, and serves on the editorial board of The Quarterly Journal of Austrian Economics. He received his bachelor's degree from Hebrew University, master's degree from Witwatersrand University and PhD from Rands Afrikaanse University, and has taught at the University of Pretoria and the Graduate Business School at Witwatersrand University. He is a frequent contributor to the Asian Wall Street Journal, among many other popular and scholarly venues. His email address is fshostak@ords.com.au
AEN: Do you find Austrian economics useful in your day-to-day work?
SHOSTAK: I think it's important that clients understand the rationale behind your thinking. The Austrian School makes that possible. Clients relate to it very easily, and there's plenty of available literature with which they can follow up. On the other hand, most businessmen cannot understand econometrics, even if they sometimes pretend to because they don't want to appear stupid. But the really smart ones want to know why you think the way you do. You can't just say: "that's what the model says." Serious businessmen won't buy that. Neither will they be tricked into thinking their advisers are oracles. I never pretend to predict the future but only to suggest possibilities based on real events and realistic theory.
AEN: The job of chief economist for a major investment firm usually involves mathematical wizardry.
SHOSTAK: I was trained as a mathematical economist. My dissertation topic was "An Econometric Inquiry into the Monetary Transmission Mechanism in South Africa." After my PhD, I went to work as the head of the econometrics department for the major Johannesburg bank. While there, I built one of the first large macroeconomic models in South Africa. I visited the Wharton School of Business, showing it off and impressing all the math jocks. After working ten years on the project, I began to have doubts, and those doubts grew.
At some point, I decided to throw myself back into thinking about the basis of economic theory. I eventually read Murray Rothbard's Man, Economy, and State, and it permanently changed the way I thought about economics. He began with human beings as they are and as they act and as they choose-points that macroeconomic models cannot take account of. It became clear to me that most of what I was doing was based on the wrong foundation.
The big problem in economics is not that it lacks technical sophistication; the problem is that it lacks philosophical sophistication. When economists do attempt to give the science a philosophical justification, the results are unimpressive. It usually comes down to a defense of patently incorrect assumptions about the world.
But why should we assume things that are incorrect? The answer used to be that you can know good models by their predictive power. Today, few believe that, so the defense of implausible assumptions now comes down to this: they are necessary to create models. This is just a vicious circle, when the starting point and the ending point are the same. This is just a con-job.
From a Rothbardian point of view, economic theory must stand on its own. It doesn't require a mathematical proof but a logical one. It is valid in all space and time because it deals with unchanging laws of cause and effect that emanate from choice.
This is not captured in mathematical functions. If you say y is a function of x, you are trying to dispense with causality and you imply that relations between facts are brought about apart from choice. But in the end, human beings decide how much to spend, whether and how much to invest, and so on. If you throw this idea out, you can create elegant models of anything you want, but they have no bearing on reality.
AEN: While in South Africa, did you know Ludwig Lachmann?
SHOSTAK: I attended his private seminar, which he ran out of his house. What aroused my attention was his attack on quantitative economics. I remember thinking: there must be something wrong with this guy. But he invited me to join his seminar, and I always found him interesting. He lectured and we heard papers by others, and I presented some.
Even in those days, Lachmann emphasized uncertainty and the unknowability of the future. Much of it was sound, but he tended toward nihilism, the assertion that we can never know anything. I must say it wasn't until Hans Hoppe's article on that subject in the old Review of Austrian Economics that these issues were clarified for me.
In any case, in one seminar, he mentioned the debate between Keynes and Mises. I wondered who this Mises guy was, and I became very curious. Lachmann let me photocopy his copy of the first edition of Human Action, and I read the whole thing. I must admit that I couldn't understand a word of it. I was very upset because I thought of myself as a top economist, a member of an elite corps of econometricians. For my own sake, I remember hoping that Mises was just writing rubbish.
After that, I read Henry Hazlitt, whose work I found comprehensible but childish, intriguing but not rigorous-or so I thought. Later I changed my mind. In any case, Hazlitt footnoted Rothbard, and finally I found the economist who could, for me, make the case for the Austrian School.
In my opinion, Man, Economy, and State is better organized, more precise, and more focused than Human Action. Rothbard writes for the mainstream economist and in a language he can understand. Part of the difficulty of becoming an Austrian economist is that it requires a different vocabulary. Rothbard makes the transition much easier.
In fact, I attribute the rise of the Austrian School in our times, whether in academia or the financial world, to Rothbard's writings. They have had far more influence than is usually admitted, even by Austrians themselves. That so many claim that their primary influence is Lachmann or Mises or Hayek is due to the natural tendency to rally around thinkers who speak more obscurely as a way of congratulating oneself on one's interpretive capacities. It is Rothbard who has taught the world of today Austrian economics.
AEN: Was Lachmann a classical liberal?
SHOSTAK: Yes, he was, but he also had a great deal of admiration for Keynes. I asked him about Mises, and he said that Mises was a very stubborn person who didn't make enough of an effort to understand Keynes. If he had made more of an effort, he wouldn't be as negative toward Keynes. He also regarded Mises as arrogant, abrasive, and uncompromising.
I didn't tell him this at the time, but it is clear why Mises didn't compromise. He had strong disagreements with his colleagues. He wasn't interested in making incorrect assumptions about the world. He wanted to describe reality. Of course this led him to be an outcast after the entire profession had decided that it is perfectly fine to assume such things as all people are identical, knowledge is perfect, and output is given.
AEN: What about Lachmann's influence in the Austrian movement?
SHOSTAK: There is a long-running tendency among Austrians who have discovered the fallacies of mainstream thought to reject not just bad theory, but theory altogether. They conclude from the failure of one formal system of thought that all formal systems of thought must go. They rally around the work of Lachmann and G.L.S. Shackle and end up rejecting the existence of the law of demand, for example.
This is an enormous error. The problem with mainstream economics is not that it is theoretical and formal but that it is based on the wrong foundation and therefore generates crazy conclusions. The right response is to start from the right foundations. If a bridge collapses, you shouldn't reject the possibility of scientific geometry; you should try to figure out what went wrong with the bridge engineering plan.
Lachmann's key contribution to Austrian theory was said to be his theory of expectations. He said we live in a kaleidic world that is shaped mainly by what we believe about it and what others believe about our beliefs, etc. But Mises pointed out in the 1940s that expectations are a black box to an economist; they belong in the category, not of praxeology, but of thymology: knowledge concerning internal human valuations. We cannot make any fixed assumptions about such valuations. We cannot say they are perfect or that they are never correct about the future. We just do not know. Praxeology provides certain knowledge about unchanging facts.
AEN: How does this apply in the context of business cycle theory?
SHOSTAK: Writing in Economica in 1943, Lachmann criticized Mises's theory of the business cycle on grounds that expectations could prevent it from taking place. The idea is that businesses expect the bust and refrain from investment expansion, thereby muting the impact of new money coming into the economy. Hence, the business cycle is recast as an information- coordination problem rather than a theory about cause and effect.
The incorrect assumption here is that bad expectations are somehow the cause of the business cycle. The actual cause is the introduction of counterfeit money, which redistributes wealth and leads businesses to make calculation errors. You can have any kind of expectations you want but they will not and cannot obviate past events. This new money is an economic error which must work itself through the economy in some way.
You cannot use psychology to explain the consequence of real events. What people believe about the future cannot change the reality of cause and effect. The business cycle is a consequence of a real act of damage that, once set in motion, cannot be undone. Guido Hlsmann prefers to recast the business cycle theory into a general theory of error cycles, which gets to the core of the issue at hand: government intervention leading to bad decisions.
AEN: Which aggregate money supply statistic do you think is the most reliable?
SHOSTAK: I like the one spelled out by Rothbard in the late 1970s: money that permits instant conversion at no loss. Today this is covered by such aggregates as M2 and Money of Zero Maturity, or MZM. You need to make small modifications-removing short-term savings deposits-and you need to make allowance for institutional money.
Using this measure, it's clear that the money supply has been bouncing back since about 1992, and in the first quarter of 1999, money growth reached as high as eleven percent. This suggests to me that America's economy is very unbalanced. When and how it will tip the other way can't be known, but it will happen. Most people, including people at the Fed, are focusing on whether inflation will return. But that is not the issue. The issue is exaggerated levels of investment, particularly in the stock market, that cannot be sustained.
When the bust hits, you can bet that there will be more cries for the Fed to inflate. This will be a direct result of Milton Friedman's claim that the depression in the 1930s would have been prevented if the Fed had inflated. But he has it exactly backwards: it was the early credit expansion that created the conditions that led first to the boom and then to the bust. It was the first round of money printing that destroyed the pool of funding.
AEN: What do you mean by pool of funding?
SHOSTAK: Essentially, the pool of funding is the quantity of goods available in an economy to support future production. In the simplest of terms: a lone man on an island is able to pick 25 apples an hour. With the aid of a picking tool, he is able to raise his output to 50 apples an hour.
Making the tool, however, takes time. During the time he is busy making the tool, the man will not be able to pick any apples. In order to have the tool, therefore, he must first have enough apples to sustain himself while he is busy making it. His pool of funding is his means of sustenance for this period-the quantity of apples he has saved for this purpose.
The size of this pool determines whether or not more sophisticated means of production can be introduced. If it requires one year of work, for instance, for the man to build his tool, but he has only enough apples saved to sustain him for one month, then the tool will not be built-and the man will not be able to increase his productivity.
The island scenario is complicated by the introduction of multiple individuals who trade with each other and use money. The essence, however, remains the same: the size of the pool of funding sets a brake on the implementation of more productive-but longer-stages of production.
Trouble erupts whenever the banking system makes it appear the pool of funding is larger than it is in reality. When a central bank expands the money stock, it does not enlarge the pool of funding. It gives rise to the consumption of goods which is not preceded by production. It leads to less means of sustenance for the production structure.
As long as the pool of funding continues to expand, loose monetary policies give the impression of boosting economic activity. That this is not the case becomes apparent as soon as the pool of funding begins to stagnate or shrink. Once this happens, the economy begins its downward plunge. At this point, the central bank's monetary policy becomes ineffective. The most aggressive loosening of money will not reverse the plunge. Paper money cannot replace apples.
AEN: What do you make of the many companies that are attracting funding without actually showing profits or earnings?
SHOSTAK: In a free market with sound money, stock prices would function very much like other prices on the market. They would change relative to each other and pay an average return tending toward the normal rate of profit, with due qualifications owing to the good judgment of investors. What we see today, however, is roughly akin to a hyperinflation in financial assets. This is no different from the debasement we see in the value of money in a normal inflation.
Most economists believe that if the stock market is going up, the economy is being revived. But altering the valuation of stocks does not change reality. It is only a manifestation of what people think about the real world. And if you print money, you corrupt the signals that lead people to make rational decisions. Right now, people are being led to form false perceptions about reality. That doesn't mean that people cannot make money in stocks, but it does mean that the present rise of the stock market cannot be sustained.
In the real world, there is no way a company with no earnings can be properly valued at half a trillion dollars. And yet that is what we are seeing. Someone may say: but these companies may produce something someday. Sure, but there are limits. A new Volkswagen is a good car, and it may have a surprisingly high price due to popularity. But when the car sells for a million dollars, something has gone very wrong. It doesn't matter how spectacular the new technology is. Resources are being misallocated.
Even aside from these absurd prices, you can know that malinvestment is taking place by looking at the money-supply figures. They have been growing for years, and every time a crash or a recession is threatened, the Federal Reserve intervenes to save the day. When will all this end? There is no way to know. But the fund is not unlimited, and when the means of sustenance are not there, the growth cannot continue. The music will stop at some point, and, when it does, all the new credit in the world will not revive the economy. The new money can pour in but people will not use it to invest.
AEN: This sounds something like a Keynesian liquidity trap.
SHOSTAK: There is a superficial commonality. There is such a thing as pushing on string. What Keynes describes, however, he does not explain. Only the Austrian cycle theory can do that. A good example can be found in the Asian crisis. Paul Krugman says that Japan fell into a liquidity trap. Why? He doesn't know. He just describes it as an unfortunate state of mind adopted by the citizens, one that can only be cured by printing money.
But there is no need to resort to psychological explanations for why the Japanese are reluctant to borrow. It is clear that the pool of funding was unable to support the level of investment that had been subsidized by excess credit creation, averaging 9 percent per year prior to the crisis. When the central bank raised interest rates, the bubble burst and all the misallocation-which is to say the robbery-was revealed.
How do you recover from a crisis? The Japanese government continues to inflate and spend money. This is incredibly wrongheaded. To create more money is merely to replicate the error that brought about the problem in the first place. And yet, virtually every economist, from Keynesian to monetarist, recommends this disastrous path as the way out of recessions. The only path to recovery is to allow the bad investments to wash out of the economic structure and allow the pool of funding to be replenished.
AEN: Why is inflation still considered the preferred path of economic recovery?
SHOSTAK: It represents a complete misunderstanding of the purpose of money. The purpose of money is to facilitate exchange. It cannot create or sustain economic growth. It is no substitute for productivity. No matter how powerful a central bank is, it cannot revive an economy that is suffering from a credit-generated bust.
Also, mainstream economists have a hard time understanding the theoretical basis of a misallocation of resources. This is due to their economic method. Misallocation cannot be put on a graph and it cannot be represented in a mathematical equation. It has to be understood in light of market theory, which mainstream economists only embrace to the extent it can be modeled.
Think about the statistic Gross Domestic Product (GDP), from which most all economic indicators are derived. What is it? The value of goods and services produced expressed in terms of money, with the real GDP arrived at by dividing it by some meaningless deflator. If you print more money, you spend more money and GDP goes up.
But this does not reflect economic reality. Neither does the GDP deal with stages of production. It should be clear, then, that the GDP is not a reliable indicator of economic growth. It does not reflect malinvestment and, moreover, it is subject to manipulation depending on monetary policy.
AEN: Austrians are sometimes said to regard recessions as the "good" part of the cycle.
SHOSTAK: This is because recessions reveal an underlying reality. They expose a lie that has been generated by credit creation. In Malaysia, for example, the government had been trying to build an Asian version of Silicon Valley, to compete with the US. They had massive structures and companies and plans. But none of it amounted to anything. It was no more valuable than an Egyptian pyramid. The virtue of a recession is that it reveals the truth.
But this truth is difficult for people to face. Economists spend an enormous amount of energy inventing policies to keep the truth from being revealed in recessions. This is what accounts for the hysterical fear of deflation, which is considered to be the worst thing an economy can face. Instead they recommend more inflation. In fact, in an inflated economy, a deflation is exactly what is needed.
The International Monetary Fund (IMF) has improved its understanding of the importance of recessions. In Japan, for example, its economists said that banking and the industrial sector need to be cleaned up. At the same time, the IMF is still pro-credit creation. In Indonesia, with the IMF's blessing, money expansions were running 60 percent and more. In South Korea, the rates were at 35 percent.
What does this accomplish? Nothing but further economic destruction. You cannot eat money. To get the economy back on a sound footing, you need to store up a new pool of funding-the real stuff-so the capital stock can be replenished. That requires sacrifice in the short term.
I fully expect Asia to crumble again. Last year's major crisis was a result of bad fiscal and monetary policies, and those haven't changed. Neither has the economy adjusted.
AEN: What about the currency board option?
SHOSTAK: It produces a better result than the present system because it defangs the central bank. To that extent, it is a good step. But it creates problems of its own. The currency board must choose some existing currency on which to base its system. Doing so makes the currency-board country monetarily and politically beholden to the host country, whether it be Germany or the United States.
The best solution in these countries is to stop printing money and adopt a pure gold standard, defining their own currency in terms of gold. No country is too small to make this feasible. Such a country might be opposed by the US, but it would become a magnet for investment. It would not be vulnerable to outside shocks or outside political manipulation. A country with a gold standard wouldn't have to pay any attention to Alan Greenspan. Most importantly, its productive sector would be built on a solid financial foundation.
Of course central banks are working to undermine gold right now, just as they have for most of this century. Their recent sales of gold suggest that they would like to get rid of gold completely. Even from their own point of view, this is crazy. The current monetary system is completely unstable, and unloading gold can only destabilize the system further.
AEN: How regulated is the financial sector in Australia?
SHOSTAK: About as regulated as the US, which is to say partially so. In the early 1980s, we had what is called financial deregulation, but this phrase is a misnomer. Because money is unsound and the central bank still has the power to inflate and provide guarantees against financial failure, deregulation unleashes financial institutions to conduct business unchecked by genuine market forces.
This is what happened in the savings and loan crisis, an experience that foreshadowed the financial crisis throughout Asia. It was this very deregulation that opened the spigots, and brought about the huge boom-bust cycle.
The lesson is that you cannot have financial deregulation and also have a central bank. The two are incompatible. The whole point of a central bank is to make the banking system unaccountable to market forces. Whenever the banks are in trouble, there is a lender of last resort. No other business entity enjoys such a privilege.
AEN: How powerful is the Fed in your part of the world?
SHOSTAK: Its power to do evil is enormous. Its bureaucrats exercise the dominant influence at all G7 meetings, as well as the Organization for Economic Cooperation and Development (OECD) and the World Bank. It works to coordinate world policies to prevent anyone from getting out of line. The Fed's ideal is a world monetary system that it manages completely, but, for political reasons, it is unable to achieve this.
So in the meantime, its main goal now is what it has always been: to provide a safe and profitable working environment for its member banks via monetary policy, which is to say, credit expansion. This is what is behind the Fed's attempted bailouts of Mexico and Asia. It was acting to protect the assets of its member banks' portfolios.
More generally, the Fed's actions generate inflation and the business cycle, and create artificial uncertainty in the market. It cannot be known in advance what policies the Fed will adopt, and neither can you know the precise timing of the effects. Just speculating on the Fed's actions swings markets in wild and unpredictable ways. I have to laugh every time the Fed demands that the portfolios of foreign central banks become more "transparent." No institution is more clouded in secrecy and obfuscation than the Fed. We can only guess at what it has done or is doing.
AEN: This is one reason you don't accept the Efficient Markets Hypothesis (EMH).
SHOSTAK: It's not only the Fed; uncertainty is built into the core of the market itself. The whole theory of the EMH is ridiculous. They are saying there is no reason for market analysis. All that can be known is known and reflected in the market price. If this were true, there would be no profits. There would be no business cycle.
EMH is another error that stems from a misapplication of mathematical techniques to human action. They examine past behaviors and develop probability distributions based on them, as if past behavior can somehow be a guide to future behavior. But the science of probability breaks down insofar as human choice is involved. There is no normal distribution in human affairs. In some ways, the EMH represents the opposite error of Lachmann. It goes from believing that nothing about the future can be known to assuming that everything about the future can be known. The whole question is mistaken. It is not a question of whether or how much knowledge is out there. It is a question of whether people have understood the information and acted upon it. Plenty of knowledge that is available may not be reflected in the price. The price only reflects knowledge that market participants believe is relevant to market conditions and have thereby acted upon. The market does not have a life of its own and it is not a god; neither is the market random, blind, and aimless.
The market is made up of human beings who are radically different from each other. We have different goals, different kinds and levels of information, and face different environments. Discovering how this works itself out in voluntary exchange is the task of market analysis. Economics is a qualitative, not quantitative, science. It's amazing how many errors in economic theory stem from the failure to understand this.
AEN: You don't find the recent critics of the Austrian School very compelling?
SHOSTAK: Take a look at Brian Caplan's article in the Southern Economic Journal. It is an apologia for fudging one's scientific standards. It's true, he says, that utility is not cardinal but ordinal, but there's nothing wrong with indifference curves even though they assume cardinality. Why? Because it's easy and nothing important is compromised. But he's wrong. The assumption that people's utility functions can be compared mathematically opens up a Pandora's Box of economic and social planning.
He further defends the idea of indifference on grounds that such a state of mind is actually possible. But economists don't care about psychology; they care about action and choice. Indifference is not an economic category. The whole point of economic theory is to explain the implications of choice. People must set priorities and act on them. Economic theory consists of elucidating causal relations between actions and events, not speculating on states of mind or weaving tales through graphs and equations.
Caplan further notes that Rothbard criticizes the continuous function assumption behind smooth curves, preferring to deal only in discreet units. He then claims that Rothbard himself dispensed with his critique in order to draw demand and supply curves. In the first place, Rothbard was merely using the curves for illustrative and not theoretical purposes, and he put them in context in a way which neoclassicals do not. Rothbard's graphs illustrate but do not determine the theory, and there's a huge difference.
But there's a more fundamental point: Caplan never rebuts Rothbard's criticism of the continuous function assumption. Again, Caplan seems to be suggesting that he might have been correct, but then claims it doesn't matter. But of course it matters, if we care about getting the theory right. As scientists, we should not adhere to theoretical assumptions about the world that are false.
But mainstream economists do this all the time, just so they can use mathematics. If some point doesn't fit into a graph or equation, it is just thrown out. That is why most economists today end up doing nothing but analyzing various nonsensical states of equilibrium. Their priorities are wrong. Our purpose should not be to do math but to arrive at true theory.
AEN: Apart from business cycle theory, what aspects of Austrian economics are useful to you?
SHOSTAK: I use the foundational issues of choice and human action on a daily basis. But the great gift that Austrian economics gives practitioners is the ability to think logically about all aspects of economic life. There are so many investment fads out there. They come and go every season. With Austrian economics, you can easily spot the fallacies in these new theories and stay rooted in reality. Over the long-term, this is the best survival mechanism I know.
Volume 16, Number 4 (Winter 1996)
An Interview with James Grant, editor of Grant's Interest Rate Observer
AEN: Your argument about business cycles in The Trouble with Prosperity rests heavily on the work of the Austrian economist Wilhelm Röpke instead of the more well-known Austrians.
GRANT: I am an observer of the contemporary scene, a journalist, rather than a theorist. I picked up Austrian economics almost everywhere except in school. It came to me, and I to it, in the way that the Austrians say that so many good things happen, that is, by accident, rather than by design.
Over the years I read Mises, Hayek, Rothbard, and others on interest rates, capital, and the business cycle. I've long been inspired by Henry Hazlitt's career, someone who wrote as well as he did, and as long. To think that this man professed the ideas he did in the pages of the mainstream press is certainly startling and revelatory.
I chose to feature Röpke because of his book Crises and Cycles, which appeared in English during the Great Depression. He offers a clear and forceful exposition of the mechanics of the Austrian interest-rate and business-cycle model, and the very difficult but rewarding structure of the theory itself. Vera Smith must have done a great job in translating the work. By the way, I recommend Vera Smiths book The Rationale of Central Banking as a further elucidation on Röpke's already clear theory. I know there are all sorts of holes in my bibliography; there might be better and more faithful explanations than Röpke offers. But I really do recommend this to people for its simplicity.
AEN: In your book you refer to the "welfare state of credit"?
GRANT: It is a structure of regulators, lenders, and borrowers, and the system is dedicated to stability, the greatest good of the welfare state of credit. The Federal Reserve sits at the head of the table. Somewhat below the salt are the various private institutions not deemed critical to the stability of the system itself.
Above the salt are the institutions that are too big to fail and the regulatory bodies. This includes the Comptroller of the Currency, the FDIC, lenient bankruptcy law, and the whole structure of fiat money generally. Fed policy with respect to domestic interest-rate manipulation and foreign-exchange manipulation also figure into it.
The system is established to avoid runs, panics, depressions, financial turmoil, and other upsets. The idea is to head off the contractions before they happen. It is the financial counterpart of the more familiar welfare state of income and of labor. The welfare state of credit is built to resist a repeat of the events of 1907 and 1931, just as the welfare state of labor--including the 1946 Employment Act--is built to forestall another Great Depression.
AEN: And what is the consequence of this welfare state?
GRANT: To promote great bull markets and excessive risk taking in the financial and investment market. The fiscal and labor welfare states generate the perverse effect of feeding the very diseases they are supposedly trying to cure. In a similar way, the welfare state of credit feeds speculative frenzies and excessive risk taking in the financial and investment markets, while attempting to prevent the losses associated with excessive risk taking. It creates the boom that causes the bust, but it attempts to abolish the bust.
The long-run consequence is to subsidize instability and economic stagnation in difficult-to-predict ways. The boom-bust can appear in specific sectors and at other times in whole industries. But it doesn't often appear in extreme ways at the macroeconomic level. The system is designed to prevent that from happening, and it usually does.
It's been more than twenty years since the American stock market has been through a bracing bear market. My book argues that this is not evidence of success; it's evidence of the artificiality of the system. Our milder down cycles have coincided with ever weaker up cycles. This is the key to understanding the characteristic torpor of late-20th-century GDP.
AEN: Usually the Fed is criticized for being too strict in its lending standards.
GRANT: That is exactly the misconception. To my mind the Fed is a cross between the late, unlamented Interstate Commerce Commission and the Wizard of Oz. It is a Progressive Era regulatory body that, uniquely among the institutions of that era, still stands with its aura and prestige intact.
It is a remarkable thing that people believe the Fed can and does assure peace and prosperity. People believe the Fed can do just about anything, up to and including the prevention of tooth decay. Greenspan has almost been canonized. Notably, Paul Volcker, in the heat of the ultimately successful anti-inflation fight of the early 1980s, enjoyed no such lofty reputation.
AEN: How do you go about evaluating the Fed's reputation?
GRANT: As a financial practitioner, I try to imagine that abstract financial and economic ideas can be expressed in the form of a publicly traded security. So I think of the Fed as a stock. As a publicly traded company, how would it be evaluated in the marketplace? Where would its stock trade? Where would the stock of a managed currency generally be trading these days as opposed to where it had been trading in the past?
In 1981, after Volcker had taken over, the Fed was figuratively trading at about three times earnings, about one half of book value, and a dividend yield of 15%. The Fed was regarded as either impotent or incompetent or more likely both. It was for sale. Inflation was a perpetual pox on the United States, and there was nothing to be done about it. Volcker was merely giving us gratuitously high interest rates. That was the Feds standing when we all should have been long on the Fed, and we should have been selling gold and buying U.S. Treasuries. The Fed was written off as a nullity.
AEN: And today?
GRANT: Fifteen years later, the Fed is trading--figuratively--at forty times earnings, five times book value, and it is yielding nothing, because people now believe in the integrity and the efficacy of managed currencies. They believe furthermore--and even more remarkably--in the clairvoyance of these intrabeltway economic planners known as central bankers.
Central planning may be discredited in the broader sense, but people still believe in central planning as it is practiced by this one institution manipulating one interest rate. The Fed does not set rates; it sets a rate, namely the federal funds rate. Its first and second cousins--including overnight repo rates--are affected more or less directly according to their proximity to the funds rate in the yield curve. The Fed doesn't control the long bond; it merely influences it, and very indirectly at that.
AEN: Why do people believe the Fed is all-powerful?
GRANT: I'm still stunned they do. I dont know why, except that the welfare state of credit has been quite successful in perpetuating the greatest bull market ever. It's hard to hate. Greenspan and the Fed are glad to take the credit. And this is what I fault him for more than anything. I dont fault him for giving us the wrong rate. I'm not sure if anyone knows what the right rate should be; the number one fallacy of the present monetary system is that people presume to know.
But Greenspan knows better, and knowing better, he still pretends he is the financial wizard the American public wishes him to be. People need to believe that somebody is in charge. The idea that no one is in charge would not surprise or disturb the proponent of Austrian theory. But I think it would not embolden the average buyer of mutual funds. People believe that Greenspan is out there, not only knowing what the right rate is, but also giving it to us.
AEN: Why do you say Greenspan should know better?
GRANT: If anyone in the federal bureaucracy could write an intelligent essay on the thought of Ludwig von Mises, it would be Greenspan. He has been presented with these ideas; he even professed them at one point in his life. Instead, he leads us to believe that by the manipulation of one interest rate among uncounted interest rates, he can regulate the metaphorical temperature of the economy to give us 72 degrees four seasons out of every year. He loves the game. He loves being The Man.
AEN: How would he respond to your criticism?
GRANT: He would say, "that's not true: I've often warned about cycles." But he hasn't. He has never come out and mouthed the crucial Austrian insight: artificial booms cause busts. He has never said that when you artificially subsidize credit creation, you disturb the markets investment architecture. Greenspan has been intellectually derelict. He will talk about cycles as outside nuisances that are correctable by a deft tug on the funds rate.
Greenspan's colleague Alan Blinder was particularly cocky about this after he left the Fed. He would say: "If we had only gotten this right in 1990, we wouldn't have had a recession." Imagine. If they can get the right funds rate, well never have another downturn. Wow. That's pretty good! How did the Soviet state ever come to grief? It didn't have the right interest rate!
Again, once you accept the principles of the Clairvoyance Standard--that the central bank, knowing the future, should act to improve it before it happens--then you can argue about who is the clearer clairvoyant. The method itself is unsound.
AEN: Isn't there a sense in which the Fed is responsible for recession?
GRANT: If it follows a Fed-induced bust, it is only indirectly responsible. The Fed is not responsible for the institution of a business slump and neither should it attempt to outlaw it. The boom sows the seeds of its own destruction. Remember, there were plenty of recessions before December 22, 1913, when the Fed was enacted. I don't know of any state-of-nature economy in which there is perpetual prosperity.
AEN: That brings up a tension in your book. Do you regard the business cycle as endogenous or exogenous to the market?
GRANT: As an observer of day-to-day events, it seems to me that, for causes that are not set in motion by a central bank, but for other reasons, people will take it into their heads to overdo it or underdo it in markets. This is true in specific sectors or financial markets generally. That's the nature of the market; it gets things wrong and self corrects.
For example, I can't account for the last three or four years in the stock market simply from the point of view of Fed actions. Of course, you can say: by suppressing the funds rate in 1993, the Fed set in motion a credit-induced speculation that has carried well beyond the monetary event itself. But the proximate cause set in train a speculative frenzy that has far outlasted the first cause. Even apart from Fed intervention, you can't rule out the power of conditioned behavior.
AEN: In what sense?
GRANT: For a time, the funds rate was the highest point on the Treasury-yield curve up to about five years, which is arguably too high. A mechanistic view of the Austrian theory might predict a downturn. Yet the speculative frenzy continued. And compare this with previous decades. From the time of the crash in 1929 to the ensuing liquidation of 1932, all the way until 1954, people swore off common stocks. There were many times during that period when the Fed gave us a preposterously low rate of interest, one that should have set in motion a credit-induced boom.
But in 1946, consumer prices rose to the mid-teens, bonds yields were at 2.25%, yet there was no rush to take out bank credit with which to finance new projects. Why? Yes there was regulation. But more to the point, there was a settled attitude of risk aversion. There was a morbidity about the next depression.
The relationship between the Fed and the macro-economy is not set in stone. The Fed's past actions and inactions, and the expectations people have developed about its future actions, have a profound impact on the financial culture and on the direction of the cycle.
AEN: Are you suggesting a revision to the orthodox Austrian business cycle model?
GRANT: Not at all. I'm suggesting that we avoid the temptation to tear the Austrian model away from the larger context of Austrian theory. We don't want to end up with a Rube Goldberg contraption that proves useless in explaining real events. The larger body of Austrian thought includes insights about uncertainty, subjective valuations, and peoples perceptions of events.
We can explain events at some level by referring to the last credit experience. But week to week, there is a lot going on in markets that has to do with attitudes and collective impulses that are not immediately reducible to central bank actions. That's why Austrians must be cautious about rendering the business cycle theory too deterministically, while forgetting other parts of the broader theory of market behavior.
AEN: Even a central bankers words, then, can mean more than his actions in this hothouse.
GRANT: Right, and so can silence. To the extent that people regard Alan Greenspan as the protector and defender of the financial faith, and to the extent that Greenspan does not say cautionary things before the Senate Banking Committee, to just that extent, he is guilty of a sin of omission.
Should Greenspan be telling the market where fair value should be? No. But people have come to take him as the J.P. Morgan of the day--the leader of the financial markets. And he is not saying the things he ought to say to make people less inclined to ride to temporary riches during a false recovery.
AEN: You write that Marriner Eccles, like Greenspan, often warned the Senate of the danger of inflation.
GRANT: That's standard central-banking boilerplate. They know what to say and many of them say it very well. Not all do. For his part, Greenspan speaks central-banking Esperanto very well, which is not the same thing as lucid speech. It's not intended to be.
Central bankers may decry one form of inflation. But among the contributions of the Austrians is the insight that there can be an inflation of assets as well as an inflation of prices. In Wall Street and the financial press, inflation means one thing only: the CPI going up. But to students of the Austrian School, that isn't even half of it.
AEN: How can we tell, then, what the Fed is really up to?
GRANT: It's only possible at the extremes. Day to day, it is difficult to know. Certainly in September 1993, it was clear what the Fed was up to. The headline in Grants was: "Lets Borrow Some Money." It was my way of declaring my conviction that rates were too low and were bound to go up.
Here's one way you can tell. When the Fed imposes a really low rate, the speculators will seize it opportunistically, will borrow at that rate, and will buy securities yielding a better rate. If the Fed has given us a 3% funds rate--financing costs, in the phrase of the bond market--people borrow at 3% and invest at 4.5% or 5%. You can do this all day and all night.
There are ways of keeping score on this. When you see loans piling up to finance securities, you know the Fed is financing an old-fashioned "Boys Night Out." That was plainly true in late 1993 and into 1994.
AEN: This appears analogous to what happens to the capital markets in a more traditional Austrian-style boom.
GRANT: In the same way there is a structure of production, there is a structure of finance and a structure of speculation. It is given to us by the yield curve, the alignment of rates over time. It can be bent out of shape by the Fed just as the relationship between capital and consumption can be distorted.
The distortion of the structure of speculation results from a stimulus in the front end of the yield curve. This enhances instability because the entire structure becomes vulnerable to a change in the cost of borrowing, that is, a change in the funds rate. When the Fed tightened in 1994, that structure toppled down. It caused the most loss-ridden year in the history of the U.S. bond market.
AEN: And Austrian theory helps you visualize the trends?
GRANT: If you know that the economy is dominated by the time-bound structures of production and speculation, the world comes into clearer focus. These are not just abstractions. We applied this notion of artificial stimulus very profitably in 1995 by focusing on the semiconductor industry. We saw that one consequence of this 3% funds rate was a capital spending boom in semiconductors. We said that Micron Technology--which was then in the most active list at the New York Stock Exchange--was overvalued. The stock later went from 94 to 30.
Of course, we've been wrong a lot too, especially on the overall direction of the stock market. But we have been very right in certain situations in which we have been able to apply the ideas of the Austrian School.
AEN: How do you sort out short-term glitches from structural distortions?
GRANT: What we do is look for extremes in markets: very undervalued or very overvalued. Austrian theory has certainly given us an edge. When you have a theory to work from, you avoid the problem that comes with stumbling around in the dark over chairs and night stands. At least you can begin to visualize in the dark, which is where we all work.
The future is always unlit. But with a body of theory, you can anticipate where the structures might lie. It allows you to step out of the way every once in a while. So I'd like to put in a plug, not just for the theory itself--as elegant as it is--but for the application of the theory for calling the turn of cycles in the workaday world.
AEN: What about the monetarist ideal of stable money?
GRANT: To achieve it requires, at minimum, a clearly defined and controllable monetary aggregate. If that were ever possible, it's not anymore. Nobody even cares what the aggregates say. Some people pay attention to total debt. But as to M2, M1, M3? No. They are as outre as knickers.
It's not just a matter of fashion either. It is fundamental. Technology has allowed one dollar to do the work of many dollars. The rate of turnover in money has been heightened enormously by computer technology. Every day over one international banking wire, the CHIPS wire, more than $1 trillion worth of transactions take place.
There are all sorts of wondrous technological advances in money. So-called "sweep accounts" are one example. Suffice it to say that it was always hard to count this stuff called money. It is harder now because it moves so fast. There are many near-money things that seem to do the work of money in transactions. So monetary aggregates no longer seem to count.
Doctrinaire monetarists don't give up so easily. They still insist that bank reserves are the thing to watch. If you know bank reserves and the growth rate thereof, you will be closer to the kingdom of Heaven. I don't see that.
AEN: Is money counting impossible in practice and theory?
GRANT: There is such a thing as a money supply, but it is quicksilver. Just when you think you've captured it, you haven't. There are all manner of ways for money not to be counted. However good the Fed has become at counting money, the private market has been that much better at reinventing it. The proof of the lack of utility of monetary aggregates is that people don't pay much attention to them.
AEN: That goes for the Fed too?
GRANT: Right. The Fed will give a growth target for M2 and M3 (they've stopped trying to target M1). But these don't mean much. Austrians are dead set against counting things you can't count. Increasingly money seems to be one of those things. But that shores up the Austrian end of the debate, and poses terrible problems for those who believe in monetary central planning.
AEN: Are there any other techniques beside watching the yield curve to determine what the Fed is up to?
GRANT: The dollar exchange rate is worth watching. If there are too many dollars in the world, other things being the same, the dollar will tend to weaken. The trouble comes with the reserve currency fandango: foreign central banks are hoarding dollars. They buy dollars and then obligingly invest them in the securities issued by the very government that is helping to perpetuate the payments deficit. Once you get over that hump, you have to ask: what does this array of exchange rates and yield curves tell you about Fed actions?
Then there is the statistical way of looking at the Feds actions itself. The Fed is a bank, at least in form and structure, and it publishes a balance sheet. We track this and study the rate of its growth. We look at the rate of turnover in deposits. We look at the level of borrowing to finance speculative holdings and dealer holdings of Treasuries. We look at mutual fund flows and central bank purchases of dollars and the like.
We are eclectic because changes in Fed policy occur at the margin and were going to have an edge if we find trends in an obscure place rather than a familiar one. We look at extremes, obscurity, and the contrary outcome because that's where you get the best odds in investment and speculations.
AEN: Does all this make it impossible to forecast change in the overall price level?
GRANT: Harder, certainly. But that's not where the real action is. It is possible to travel from the bottom to the top and back to the bottom again of a business cycle and see no changes in overall prices for final goods. That's just what Murray Rothbard pointed out about the 1920s. Like the 1990s, it was a time of material progress. Costs were falling and prices should have been falling but weren't, ergo, Murray inferred there was a credit inflation. And you could see that expressed in equity prices, and the prices of securities and claims. I think that is what is happening at this moment.
AEN: Will the newly-created indexed bond improve our discernment abilities?
GRANT: The theory is that it will reveal future inflation to policymakers. But they will be severely disappointed. There are a number of different inflations. Whichever one they focus on will be the wrong one. And will not improve the information available to the Fed to run monetary policy. Moreover, it doesn't excite me at all as a speculative or investment vehicle. Any securities innovation coming from the government leaves me cold as a first principle. You can have my share of any and all future indexed bond issuance.
AEN: Is it another example of the attempt at monetary central planning?
GRANT: It is worse. It is a symptom of Greenspan's fundamental failing that will prove to be his undoing. Before this is all over, there will be a big speculative upset, a loss of faith in financial assets, and a loss of faith in the steward of financial markets: Greenspan himself. His tragic flaw is that he thinks--contrary to the teachings of the Austrian masters--that there is some piece of data that will allow him to see the future clearly and head it off at the pass. He really believes that, notwithstanding what he knows about Mises.
There is no worse error. Somebody once told me that when Greenspan went to Washington, he felt that at last he would have the information he needed to make him a great economic forecaster. He evidently thought that in the upper-left-hand drawer of his desk, there was going to be a chart book that would show him everything.
AEN: There has been a perception that Greenspan and the Clinton administration are very close.
GRANT: It isn't clear that his refusal to raise rates before the election was necessarily political. But Greenspan's career has been an essay in careerism. He has sought out power and prestige, the great and the good, and wants to be one of them, and he is. He has arrived. He is an establishmentarian who is going to do things in the establishmentarian way.
AEN: What do you think was really behind the Mexican bailout?
GRANT: The peso has never had a bull market. It has always deteriorated. Its melt rate has been hotter and colder, but it has never failed to melt. It is remarkable that, even for a few fiscal quarters, people would suspend their knowledge of its certain path. It is no less remarkable that the Mexican people put up with what they put up with.
It goes back to the primary goal of the welfare state of credit: stability. That's what Robert Rubin and Greenspan want. There is nothing quite so unstable as a run on a currency, as a run on a mutual fund that happens to have gotten itself too long of Mexican Treasury bills. The taxpayers are not out of pocket but there ain't no free lunch, and the Mexican bailout was an example of a particularly unappetizing peanut-butter-and-jelly sandwich.
Stability is a false ideal. Instability is a vital and necessary part of the capitalist drama. The purpose of the downside of the business cycle is to make the economy clean and honest again. To reduce the downside is to dampen the upside.
AEN: Is the deficit really going down?
GRANT: To find the deficit, look not at the published number. It doesn't incorporate the debt of the Social Security trust fund or other pockets of government debt. Look at that annual addition to public debt. While the reported deficit is falling dramatically, the rate of growth in public debt is slowing, but not as much.
Another way of getting at the deficit issue is to ask what the deficit signifies for interest rates. Between 1981 and 1993, when the deficit was expanding at a break-neck pace, bond yields were being chopped in half. If the reason people care about the deficit is the putative connection it has with mortgage rates, that connection does not exist. The deficit is bad because it suggests a profligate government and an unsound monetary regime, and because it is eventually paid at public expense.
AEN: Should we deplore the current boom?
GRANT: I'm at my worst when I deplore. I'm supposed to be thinking about how to get ahead of the curve. How do we profit from whatever excess is upon us? The excess could be one of extreme caution, but we haven't seen that for 15 or 20 years. I'm a bear in a bull market, which is wrong. The really seasoned observer is supposed to be in step with things, not credulous of the existing trend, but still not fighting it.
AEN: It just goes to show that even the smartest forecasters can't know it all.
GRANT: Thanks, but here's something I'd like a full-blown Austrian economist to tell me. Why is it that a certain redundancy of credit and money in central bank assets at one point in the cycle can give rise to inflation in common stocks, but at another point in the cycle, it gives rise to an inflation of goods and commodities but not of common stocks? Why does the excess seem to flow into variable channels? In 1946, we got high meat prices and low stock prices; in 1996, we get low meat prices and high stock prices. Why is that? Maybe an Austrian business cycle theorist can write a book--in English--explaining that mystery.
AEN: What if deposit insurance were abolished today? What would happen to the banking system?
GRANT: Right now? Nothing. The reason is the same reason the Nasdaq is selling at 45 times earnings, the same reason that gold wont go up, the same reason every single corporate bond in the world seems to be priced as if it were a government security. This is a bull market. In a bull market, confidence is perfect. People doubt nothing. Abolishing deposit insurance would be regarded as another wholesome Clinton reform on downsizing government. In a real economic downturn, the story would be very different.
Again, my footnote-scale contribution to the Austrian debate would be to urge people not to underestimate the collective psychology of investors, voters, the general populace at various times in the cycle.
AEN: Any comments about its origins in the 1930s?
GRANT: At the bottom of the cycle in 1933, the government introduced deposit insurance. It seemed to be a great thing for the country, a long-overdue reform, and, at last, the key to the stability of the financial system. But it was at this moment when it wasn't needed. The banking system had already been liquidated. There were no bad assets to purge because nobody was making any loans.
It was supposed to encourage risk-taking, but it didn't work. In an anti-capitalist environment, youre not going to be very successful in encouraging risk-taking by insuring deposits. That was the ironic timing of the reform. It would stand to reason that they'd take it off at the top of the cycle when the bad loans in the future were being made.
Notoriously, deposit insurance was increased from $40,000 to $100,000 in 1980. That was a fatal increase. That got the credit boom in the real estate industry rolling along. That got every two-bit S&L in the country involved in the commercial real estate business. That was the last big increase. Even the government now knows what it means to subsidize a moral hazard.
AEN: Do you think the consumer credit market is itself a creation of loose credit?
GRANT: It has been subsidized and encouraged by the central bank, and the rise of debt that has come with it, but it has a life of its own--by and large a successful life, I might add. Wilhelm Röpke criticized all consumer credit as being a product of the inflationary age. He couldn't have anticipated how fully developed the market would end up.
In Germany today, consumer credit is only a minor fixture in the financial markets; the main use of credit cards is to debit ones bank account, not to run up balances. Americans think Germans have it all backwards; the purpose of credit cards is to get yourself in debt and go to Aruba.
AEN: Does the American practice have advantages?
GRANT: America has shown that a bank can stay open 24 hours a day. It has shown that you can conduct business without a teller discovering the details of your personal financial life. That's great. The technique of consumer finance in America is wonderful. Has it opened the way to abuses? Certainly. Has it changed the nature of the economy? Certainly, for better and worse.
AEN: Yet under the gold standard, the availability of credit was severely restricted.
GRANT: Correct, and only by degree did bankers come to trust ordinary working men and women. There is nothing incompatible between the gold standard and a democratic regime of credit. Nineteenth-century bankers miscalculated and overlooked a great business opportunity when they overlooked the average American worker. Had World War I not happened, the markets would have discovered, through trial and error, that consumer credit is a legitimate and lucrative business. As it turns out, consumers collectively have presented a much better credit risk than corporations individually. That's not likely to remain true indefinitely.
The purpose of markets is to test the limits of ideas, and sometimes take them to absurd extremes. Markets tested the absurd extremes of financial leverage in the 1980s. They've tested the absurd extremes of the equity market in the 1990s. They've tested various structures of corporate finance during various cycles. Markets will test the extreme limits of consumer credit too.
AEN: You write in The Trouble with Prosperity that the military represents a kind of "shadow socialism."
GRANT: It is a distinct form. Look at the city-state collectivism of the aircraft carrier. It has all the inefficiencies of socialism, and all the quirks, complete with black markets on the hangar deck. People are buying and selling government property. Like all socialist systems, it is parasitical on outside markets.
The great paradox of the Cold War is that in the name of defending freedom, America sacrificed much of her own freedom, and even became a Garrison State. Regimentation became an important undercurrent in national life, and a destructive one. We should be thankful that the society is so resilient and adaptable. Lew Rockwell and the late Murray Rothbard always point out how the tradition of the Old Right was far more anti-militarist than today's political class, and precisely because militarism represents a threat to liberty.
AEN: Do you have personal favorites among the anti-statists of the 1930s?
GRANT: I'm a huge fan of Garet Garrett, a wonderful writer and thinker. He was a great pal of Bernard M. Baruch. I wrote a book about Baruch a while ago, and while reading through his papers, I found a correspondence between them. I came to be an admirer of Garet Garrett. He was so industrious and productive. He was such a student of markets and Wall Street among other things.
In 1922, he wrote a great book called The Driver. It was about a railroad titan, and it's clear to me that Ayn Rand--shall we say borrowed?--from this book for Atlas Shrugged. I discovered this when I was working on the Baruch book in the late 1970s.
Garrett also wrote a biography of Henry Ford called The Wild Wheel, among many other books. He wrote for the Saturday Evening Post, and for the old Evening Post. In any case, he was a terrifically prolific and high-class journalist.
AEN: Where has the Garrettian-style attachment to principle gone?
GRANT: It's certainly not on Wall Street. What makes a successful investor is, among other things, a finely developed sense of expediency. A successful operator in the stock market is someone who gets on the right side of the primary trend and stays there. He does not object if the motive force of the primary trend is an excess creation of credit by the central bank, aided and abetted by an unprincipled Treasury.
A guy like Warren Buffet is not going to come out and say, we shouldn't buy Coca Cola at forty times earnings because we know that all these things end badly. Wall Street is intrinsically and necessarily unprincipled in the sense that it does not operate day-to-day with an eye towards what is right and what is wrong. It is the citadel of expediency.
AEN: Can you give an example of something particularly egregious?
GRANT: In practical monetary terms, it was on display in the early '30s. At the urging of FDR, Congress rendered gold clauses null and void in one of its hundred-days pronouncements. Outraged creditors took the Congress to court, and the thing wound up at the Supreme Court.
What does a principled Wall Street investor-speculator do about this matter of utmost importance to the integrity of money and contract? Well, if you opposed the nationalization of money, the abrogation of contract, and the high-handedness of this fiat act by the Congress, you would have been on the wrong side of history and the wrong side of the market.
The bond market--the market that values the promise to pay money over time--shrugged off this confiscation as if it didn't happen. Treasury bond prices went higher. Interest rates went lower. This continued from 1933 until the spring of 1946. What is the role of principle in the day-to-day life of the investor? It is a very difficult thing. Is there a shortage of principle on Wall Street? Yes, and, in a sense, there is supposed to be.
AEN: Doesn't that lend support to the idea that the market is immoral?
GRANT: No, but the market is often amoral with respect to politics. And there are many episodes in which the market favored immoral outcomes. August 16, 1971, the day after Nixon imposed wage and price controls, and destroyed what was left of the gold standard, the stock market soared. Through early 1973, you could have made a lot of money by owning common stocks in the face of the worst political-economic disaster of the past generation.
AEN: Yet immorality is reinforced by the welfare state of credit.
GRANT: Immorality and irrationality. The calculation of risk and reward becomes distorted, so people take risks they shouldn't take. People believe, incorrectly, that the Fed will not allow untoward things to happen. Right now, people are going out and buying common stocks. They are paying the highest price for a dollar of dividend income they've ever paid. They are paying, in many cases, the highest price for a dollar of earnings. They are paying the highest price for a dollar of net worth of the American corporation. They continue to pay these prices, in part, because of the idea that the downside has been conquered.
AEN: Has it?
GRANT: No more than economic law has been repealed. In the boom cycle, people are not so much interested in a message that says: a bust is simply a necessary part of the business cycle. In a false prosperity, good economic ideas are marginalized. That's why Austrians should prepare right now to offer the best explanation when the tide turns, as it always does. Who knows? Maybe well find ways to make the bust intellectually profitable. In time, Austrian economics could be again seen as the mainstream theory. It should be.
Volume 1, Number 2 (Spring 1978)Gary G. Short discusses the conference, Issues in Economic Theory: An Evaluation of Current Austrian Perspectives, which occurred on January 7-8, 1978 at New York University.
Volume 3, Number 3 (Summer 1982)John B. Egger and Leland B. Yeager review William H. Hutt's book, The Keynesian Episode.
Volume 20, Number 4 (Winter 2000)Roger W. Garrison is interviewed on his contributions to Austrian Economics.
Volume 1, No. 2 (Summer 1998)Arthur Hughes, in a recent article in the Review of Austrian Economics,[1] seeks to apply the Austrian theory of the business cycle to the recession of 1990. In submitting his case, Hughes presents the Austrian business cycle theory and applies it to the evidence he has gathered. This comment focuses on the theoretical aspects of Hughes’s paper.Hughes commits two theoretical errors in his article. The first is that he associates the length of time of production with the entrepreneur’s investment-planning horizon. The second is that he fails to understand that the amount of “lead time” an industry uses is not dependent upon where in the structure of production the firm is located.Hughes, correctly, argues that higher-stage firms[2] (i.e., firms that are “further” from the final consumers in the production process) are inherently more sensitive to interest rates. He cites evidence that higher-stage firms had wider swings than lower-stage firms during the 1990 recession, and suggests Keynesian economists should stop “looking in the wrong place” and adopt the Austrian business cycle theory (p. 123). The wider swings among the higher-stage firms are predicted by the Austrian business cycle theory; however, it is the manner in which Hughes justifies this stylized fact that is faulty.Hughes’s reason why higher-staged firms have a greater sensitivity to the interest rate is based on two false assumptions. First, he states, “One big difference between the companies in different levels in the structure of production is the time that must elapse before their investments return a profit” (p. 109). Hughes implies that a higher-stage firm must wait until its good is ultimately transformed into a final consumer good before anyone can receive a return. Thus, the present value of a good in the process of production is dependent upon the length of time it takes a good to complete the production process (p. 110–11). The present value is derived from the discounted future value. Therefore, according to Hughes, a longer production time leads to a greater sensitivity in changes of the interest rate.Hughes’s erroneous construction of the structure of production stems from a confusion between the length of the time it takes a good to reach its final stage and the period of time it takes a firm to transform the good for the next stage (p. 109). The “stages” of the Hayekian triangle do not mark any particular length of time. It is not a measurement of how long the production process takes. It is merely stating that there is an order to the production process. This action comes first, followed by the next, and so forth. If we were to use Hughes’s idea that the value of a good still in the production process is simply the discounted present value of the object, then the time axis of Hughes’s figure 1 (p. 109) would have to be an objective length.In Austrian theory, a single rate of interest is used as a simplifying assumption. This interest rate is the rate of return for all stages of the structure of production. Markets that have firms which make more than this rate attract competitors, while firms that earn less than this rate suffer losses and could be driven from the market.The rate of return is represented by a uniform slope (creating the Hayekian triangle). Furthermore, the relative distances to consumer markets do not change this rate. Suppose a company in the middle of the structure of production changes its position by changing its customers so that it moves farther from the final stage of consumption. Would Hughes argue that the company’s profits change simply because it changed customers and thus moved in the triangle?The second assumption that compounds Hughes’s error is his idea that “[a] higher-stage firm, such as a coal mine or primary metal producer, often has a much longer lead time.”[3] In other words, Hughes is stating that a firm higher in the structure of production “often has” a longer period of investment (in terms of both initial and subsequent investment time). This is not true, and Hughes does not prove his conjecture. It does not follow that just because a firm is at a higher stage, that it needs more time to build its product nor is a longer time to equip a plant or train workers implied.To illustrate his point that higher-stage firms are more sensitive to interest rates than lower-stage firms because of the amount of lead time stemming from location in the structure of production, Hughes presents the following example (pp. 110–11). Suppose there is a food retailer who is close to the consumers, and a primary metals manufacturer who is not. Hughes posits that the food retailer invests in delivery trucks that can be immediately used in the production process. The primary metals manufacturer also invests, but he decides to build a new plant that will cost “many hundreds of millions of dollars, and take ten years from site purchase to full production” (p. 110). Hughes, by equating the relative closeness of the firms to the consumers with the period of time it takes for an investment to become a part of the production process, claims that the higher stage firm is relatively more sensitive to the interest rate.However, Hughes should never have linked these elements together. There is no reason to think the primary metals manufacturer is forced to invest in projects with long durations, nor does Hughes provide empirical evidence to support the claim that they do. Suppose the primary metals manufacturer bought the trucks, and the food retailer invested in a project to open a chain of stores that would take millions of dollars and tens of years to complete. This reversal does not change our economic actors’ relative closeness to the consumers, but it does reverse the conclusion of their sensitivity to the interest rate. The firm’s location on the structure of production is not the primary factor of a firm’s sensitivity to the interest rate. Methodological individualism indicates that it is the entrepreneurs who determine how sensitive they are to interest-rate risk. The expected rate of return on the investment (factoring in risk, which includes an increased riskiness for longer undertakings) coupled with the project’s degree of capital specificity determines the entrepreneur’s sensitivity to the interest rate.Hughes’s observation that higher-order goods have wider swings in a cycle is valid. Austrian theory does suggest that interest rates play a role in these swings, but for reasons other than what Hughes suggests. Hughes posits that higher-stage firms are more sensitive to the interest rate because those firms are tied to the calculation of the present value of the final goods to be sold at a future date, or they are more sensitive due to lead time (pp. 109–11). Instead, as the interest rate changes, the ability to create a more roundabout method of production changes. When economic actors change their time preferences, so that they save more and consume less, they are signaling to entrepreneurs (through the fall in the interest rate) that they are more patient for present goods. Resources are transferred to higher stages of production. When economic actors change their preferences, showing that they are less patient (i.e., a decrease in the loanable funds supply curve), resources are transferred to the lower stages of production. When the economy shifts like this, relative prices and profit margins guide entrepreneurs to specific enterprises. Each firm’s profits must meet the interest rate. If it is lower, then the firm is driven from that market; and if the firm is making economic profits, then others enter and compete them away. Thus, the interest rate is a guide to entrepreneurs, but is not used as Hughes theorizes.The interest rate, in equilibrium, is the same as a firm’s rate of return. The higher-staged firms are more sensitive to changes in this rate in the following manner. A consumer buys a finished good. The retailer must replenish his inventory and demands a replacement good from the wholesaler. The wholesaler then demands from the manufacturer, and so on. This process of imputing demand curves extends to the market where original factor resources are sold. The resource owner’s reservation demand constitutes the supply curve for this market, and a price and quantity relationship emerges. This supply curve is imputed “forward” through the structure of production, thus allowing markets to form at every stage in the production process.Each of these markets is affected by the rate of return (equal to the interest rate in a stationary state) through entrepreneurs’ adjusting their supply and demand curves so that they can receive normal economic profits. In other words, a retailer will adjust his supply curve (in the consumer good market) and his demand curve (in the market that exists between the wholesaler and himself) so that he will be making a normal rate of return.When the rate of interest changes, it changes the rate of return that is necessary to obtain normal economic profits. Relative prices compound the effect of the change at every stage. Suppose that there is an increase in the supply of loanable funds. There will be two effects. First, as consumers dedicate more resources to their savings, retailers will face a decrease in the consumers’ demand curves in their markets. As a result, retailers will decrease their demand of wholesaler goods in order that they may maintain a normal rate of profit. Second, the normal rate of profit will decrease (lower interest rates), thus cushioning the impact on the stage immediately higher in the structure of production (in this case the wholesalers) relative to the prior production stage (i.e., the retailers). The wholesaler will change his demand curve in the market between the manufacturer and himself according to the change in the retailers’ demands (which is already dampened by the change in their rate of normal returns) and according to the change in the normal rate of profit as seen by the wholesaler. As the impact of the consumers’ decrease in demand travels through the structure of production, the change in the rate of return is applied at each step. At some point in the structure of production, the compounding of effect of the change in the rate of return will dominate the change in demand. This is how the higher-order markets are able to expand while consumer market’s demand curves are falling. There are two effects of this consequence. Larger swings in higher-order goods result, and it appears as though the prices of the goods are subject to the discounted present value formula. However, as explained above, while it may look as though this is the case, the change in relative prices stems from the factors illustrated above and not from the discounted present value formula.Hughes also claims that the boom is brought to an end because the monetary authority, fearing a rapid increase in the price level, changes its policies by raising the discount rate or conducting contractionary open market operations (p. 113). While this may be true, the boom is always brought to an end due to shortages of real resources. The change in monetary policy only tends to hasten the realization of the malinvestments. As Hayek points out, there simply are not enough real resources to maintain the increase in both the new investment goods and consumers’ goods.[4]Austrian theory provides a powerful tool for the study of events such as the 1990 recession, I applaud Hughes’s attempt to apply the Austrian business cycle theory to historical events. However, we must get the theory correct before the Keynesians will start looking in the places that we suggest.[1] Arthur Middleton Hughes, “The Recession of 1990: An Austrian Explanation,” Review of Austrian Economics 10, no. 1 (1997): 107–23.[2] When referring to stages of production, the reference is made to the Hayekian triangle, which is a continuous input/point output model.[3] By “lead time,” Hughes means the time it takes an investment to be utilized in the structure of production (p. 109).[4] Friedrich A. Hayek, Prices and Production, 2nd rev. and enlarged ed. (New York: Augustus M. Kelly, [1935] 1967), pp. 85–100.
Volume 23, Number 3 (Fall 2003)
Roger W. Garrison discusses his experience being the first Hayek Visiting Fellow at the London School of Economics.
Taught by Professor Joseph T. Salerno, this course builds upon the basic analytic principles of Austrian economics including basic supply and demand analysis and the theories of entrepreneurship and factor pricing to present the fundamentals of Austrian macroeconomics.
The Austrian approach to macroeconomics was developed by the followers of Carl Menger, and in modern times included most notably Mises, Hayek, and Rothbard. Unlike mainstream macroeconomics, Austrian macroeconomics is not a body of theory separate from basic value and price theory that aims at analyzing the economy as a holistic entity apart from the individual households, firms and markets that constitute it. Austrian macroeconomics is only “macro” in the limited sense that it uses general economic theory to analyze specifically those phenomena that pervade individual exchanges throughout the market economy.
In this five-lecture course, Dr. Robert Murphy reviews the causes of the Great Depression, the response of the Hoover administration, and the New Deal. The focus is more on economic analysis rather than historical narratives, contrasting the Keynesian interpretation of various events versus the Austrian explanation in particular. Topics include the operation of the gold standard and the allegation that it inhibited policymakers from implementing the “stimulus,” Herbert Hoover’s supposed austerity program, the Friedman-Schwartz theory that the Fed’s unwillingness to inflate led to the severe downturn in the early 1930s, recent academic research showing the cartelization effects of the New Deal, and the myth of wartime prosperity. Dr. Murphy’s book, The Politically Incorrect Guide to the Great Depression and the New Deal, would be very helpful for students, but it is not required for the course. All necessary reading materials are provided.
The vastly greater productivity of a relatively-free populace makes for greater per capita tax revenue, writes Dan Sanchez. This audio Mises Daily is narrated by Clay Barnett.
Mark Thornton presents a one-minute primer on the "Skyscraper Curse". Thornton is a Senior Fellow at the Mises Institute.
A recently published article at The Week, titled “How can we unleash positive animal spirits into the economy? Change the narrative,” provides a clear example of what’s wrong with the perception of economics and why modern economic approaches, possibly aiming to amend the shortcomings “identified” by this perception, is at a loss of explaining anything important.
Perhaps the title of the article, written by John Aziz, is sufficiently telling, but let’s have a look at the assumptions and assertions in the first couple of paragraphs — and how they apply (if at all) to economics. Aziz begins:
Economics is a tough science. People are complicated — they have different (and unstable) desires, react differently to events, and view the world in different ways. Markets are complex interactions between millions of these different people.
It appears Aziz finds it highly problematic for economics that people have different desires. This is indeed a problem for a science attempting to understand or predict those desires. In this sense, I certainly feel for those psychologists working on such issues. But as an economist, it is hard to get puzzled by the statements. Rather, one feels excitement about the “complex interactions” that Aziz mentions. Yes, that’s where it gets interesting — the social phenomena arising due to individuals’ actions independently, in concert, and within an institutional framework. Here’s where the economics is. So let’s see where Aziz takes us from here:
In this respect, understanding the economy requires an understanding of people’s motivations. They invest and spend money (or withhold from investing and spending money) to fulfill certain desires and objectives, such as making a profit, building a nest egg, or simply acquiring useful goods and services. Sometimes these economic decisions are rational. Other times, instincts like greed (during an economic boom) and fear (during and after a bust) can cloud our rationality.
This paragraph is at best puzzling. The first sentence makes no sense: why does understanding “the economy” requiring understanding “people’s motivations”? It does not follow. The economy does not reflect the motivations, but people’s actions based on them. In order to understand what happens to the water when ice melts we do not need to know what the source of heat is. In order to understand the storyline of a novel we do not need to know on what type of machine it was typed or printed. Likewise, we do not need to understand people’s motivations to study the outcome of their actions.
Aziz continues:
Markets go through phases of mass optimism and mass pessimism — booms and busts. John Maynard Keynes called the forces underlying these phases animal spirits, the emotional and intuitive factors that drive economic decisions. They are an unavoidable part of economics, since there are questions that can’t be answered in an easily quantifiable way. For example, am I investing in a company selling goods and services that people want? Is the market getting stronger or weaker? Are people feeling more confident about the future or less confident? Will interest rates — which set both borrowing costs and the return on your savings — rise or fall in the future? How about inflation?
More assertions. And they’re even stranger this time. Obviously we need to throw in “animal spirits” as they are “an unavoidable part of economics” because they’re not “easily quantifiable.” It is difficult to make sense of this statement. What does it mean for the study of economics that motivations to the actions that bring about the phenomena we study are not easily quantifiable? And how can it be an improvement or a solution to this supposed problem to assert “spirits” as explanans? This is strange indeed! Not to mention how utterly unscientific such an arbitrary assertion is. (And let’s not think about the article’s outrageous mixing of Weberian-style “understanding” with “quantifiable” data.)
Let’s consult the following paragraph:
Economists have gotten vastly better at addressing these questions than when Keynes was writing in the 1930s; for example, there are now business confidence and consumer confidence indices. But many of the actions we take still depend on gut decisions, for consumers and businesspeople alike.
The power of our animal instincts and the weight of our experience can override rational argument.
At least Aziz here acknowledges where economics went wrong: John Maynard Keynes. Getting “better” here translates to doing more of the type of cheap psychological and mathematical analyses that psychologists and mathematicians would be embarrassed to even consider. And, of course, constructing indices of aggregates of what is not “easily quantifiable” appears to be completely unproblematic to Aziz. Just like the “gut decisions” that we somehow need to understand to figure out the economy.
It is perhaps interesting to understand what sort of “gut decisions” made people purchase blue rather than green sweaters on that one sunny day, but it is rather irrelevant for the fact that quantity demanded of blue sweaters increased and that of green sweaters decreased — and that this caused changes to relative prices, the production structure, etc. Unless, of course, one thinks “understanding” the economy is the same thing as being able to predict and steer it in some specific direction. Unfortunately, many (including, it seems, Aziz — and Keynes) seem to think economics as a descriptive science is somehow not enough (or even, in a strange twisting of words, unscientific) whereas social engineering is the proper way to go to “understand” economics.
One does not need to think about this for more than a brief second to realize that there is something very wrong here, at all levels. It is no wonder that modern mainstream economics fails to explain economic phenomena if economists share this strange perception of what is needed to understand the economy. Mixing cheap psychologizing, indices of the unquantifiable, and a bunch of animal spirits is hardly a recipe for scientific success.
This type of pseudo-scientific drivel is an insipid waste of time at best, but it seems to be very fashionable and appears to be central in how people perceive (and do) mainstream economics. Though, of course, it means absolutely nothing. Sooner or later even the animal spirits will succumb to this fact.
The fear of deflation serves as the theoretical justification of every inflationary action taken by the Federal Reserve and central banks around the world. It is why the Federal Reserve targets a price inflation rate of 2 percent, and not 0 percent. It is in large part why the Federal Reserve has more than quadrupled the money supply since August 2008. And it is, remarkably, a great myth, for there is nothing inherently dangerous or damaging about deflation.
Deflation is feared not only by the followers of Milton Friedman (those from the so-called Monetarist or Chicago School of economics), but by Keynesian economists as well. Leading Keynesian Paul Krugman, in a 2010 New York Times article titled “Why Deflation is Bad,” cited deflation as the cause of falling aggregate demand since “when people expect falling prices, they become less willing to spend, and in particular less willing to borrow.”Krugman, Paul. “Why is Deflation Bad?” The Conscience of a Liberal. The New York Times 2 August 2010.
Presumably, he believes this delay in spending lasts in perpetuity. But we know from experience that, even in the face of falling prices, individuals and businesses will still, at some point, purchase the good or service in question. Consumption cannot be forever forgone. We see this every day in the computer/electronics industry: the value of using an iPhone over the next six months is worth more than the savings in delaying its purchase.
Another common argument in the defamation of deflation concerns profits. With falling prices, how can businesses earn any as profit margins are squeezed? But profit margins by definition result from both sale prices and costs. If costs — which are after all prices themselves — also fall by the same magnitude (and there is no reason why they would not), profits are unaffected.
If deflation impacts neither aggregate demand nor profits, how does it cause recessions? It does not. Examining any recessionary period subsequent to the Great Depression would lead one to this conclusion.
In addition, the American economic experience during the nineteenth century is even more telling.
Twice, while experiencing sustained and significant economic growth, the American economy “endured” deflationary periods of 50 percent.McCusker, John J. “How Much Is That in Real Money?: A Historical Price Index for Use as a Deflator of Money Values in the Economy of the United States.” Proceedings of the American Antiquarian Society, Volume 101, Part 2, October 1991, pp. 297–373. But what of the “statistical proof” offered in Friedman’s A Monetary History of the United States? A more robust study has been completed by several Federal Reserve economists who found:
... the only episode in which we find evidence of a link between deflation and depression is the Great Depression (1929-34). We find virtually no evidence of such a link in any other period. ... What is striking is that nearly 90% of the episodes with deflation did not have depression. In a broad historical context, beyond the Great Depression, the notion that deflation and depression are linked virtually disappears.Atkeson, Andrew and Kehoe, Patrick. Federal Reserve Bank of Minneapolis. Deflation and Depression: Is There an Empirical Link? January 2004.
If deflation does not cause recessions (or depressions as they were known prior to World War II), what does? And why was it so prominently featured during the Great Depression? According to economists of the Austrian School of economics, recessions share the same source: artificial inflation of the money supply. The ensuing “malinvestment” caused by synthetically lowered interest rates is revealed when interest rates resort to their natural level as determined by the supply and demand of savings.
In the resultant recession, if fractional-reserve-based loans are defaulted or repaid, if a central bank contracts the money supply, and/or if the demand for money rises significantly, deflation may occur. More frequently, however, as central bankers frantically expand the money supply at the onset of a recession, inflation (or at least no deflation) will be experienced. So deflation, a sometime symptom, has been unjustly maligned as a recessionary source.
But today’s central bankers do not share this belief. In 2002, Ben Bernanke opined that “sustained deflation can be highly destructive to a modern economy and should be strongly resisted.”Bernanke, Ben.“Deflation: Making Sure ‘It’ Doesn’t Happen Here.” Remarks by Governor Ben S. Bernanke Before the National Economists Club, Washington, D.C. 21 November 2002. The current Federal Reserve chair, Janet Yellen, shares his concerns:
... it is conceivable that this very low inflation could turn into outright deflation. Worse still, if deflation were to intensify, we could find ourselves in a devastating spiral in which prices fall at an ever-faster pace and economic activity sinks more and more.Yellen, Janet. A View of the Economic Crisis and the Federal Reserve’s Response, Presentation to the Commonwealth Club of California. San Francisco, CA 30 June 2009.
Now unmoored from any gold standard constraints and burdened with massive government debt, in any possible scenario pitting the spectre of deflation against the ravages of inflation, the biases and phobias of central bankers will choose the latter. This choice is as inevitable as it will be devastating.
Interviewed by host Alan Butler, Joe Salerno discusses the peak of the business cycle and the ensuing financial crisis.
After settling at 3.9 percent in July 2011 the yearly rate of growth of the consumer price index (CPI) fell to 1.6 percent by January this year. Also, the yearly rate of growth of the consumer price index less food and energy displays a visible downtrend falling from 2.3 percent in April 2012 to 1.6 percent in January.
On account of a visible decline in the growth momentum of the consumer price index (CPI) many economists have concluded that this provides scope for the US central bank to maintain its aggressive monetary stance.
Some other economists, such as the president of the Chicago Federal Reserve Bank’s Charles Evans are even arguing that the declining trend in the growth momentum of the CPI makes it possible for the Fed to further strengthen monetary pumping. This, Evans holds, will reverse the declining trend in price inflation and will bring the economy onto a path of healthy economic growth. Evans also asserts that the Fed should be willing to let inflation temporarily run above its target level of 2 percent. He also said that an unemployment rate of about 5.5 percent and an inflation rate of about 2 percent are indicative of a healthy economy.
But how is it possible that higher price inflation will make the economy stronger? If price inflation slightly above 2 percent is good for the economy, why not aim at a much higher rate of inflation, which will make the economy much healthier?
Contrary to Evans a strengthening in monetary pumping to lift the rate of price inflation will only deepen economic impoverishment by allowing the emergence of new bubble activities and by the strengthening of existing bubble activities.
It will increase the pace of the wealth diversion from wealth generators to various non-productive activities, thereby weakening the process of wealth generation.
Evans and other economists are of the view that a strengthening in monetary pumping will strengthen the flow of monetary spending, which in turn will keep the economy stronger.
In this way of thinking, an increase in the monetary spending of one individual lifts the income of another individual whose increase in spending boosts the incomes of more individuals, which in turn boosts their spending and lifts the incomes of more individuals, etc.
If, for whatever reasons, people curtail their spending this disrupts the monetary flow and undermines the economy. To revive the monetary flow it is recommended that the central bank should lift monetary pumping. Once the monetary flow is re-established this sets in motion self-sustaining economic growth. So it is held.
Again we suggest that monetary pumping cannot set in motion self-sustaining economic growth. It can only set in motion an exchange of something for nothing (i.e., economic impoverishment).
As long as the pool of real wealth is still growing, monetary pumping can create the illusion that it can grow the economy. Once however, the pool is declining the illusion that the Fed’s loose policies can set in motion economic growth is shattered.
If, on account of the deterioration of the infrastructure, a baker’s production of bread per unit of time is now 8 loaves instead of 10 loaves, and the shoemaker’s production per unit of time is now 4 pairs of shoes instead of 8 pairs of shoes, then no amount of money printing can lift the production of real wealth per unit of time (i.e., of bread and shoes). Monetary pumping cannot replace non-existent tools and machinery.
On the contrary, the holders of newly-printed money who don’t produce any real wealth will weaken the ability of wealth generators to produce wealth by diverting to themselves bread and shoes, thereby leaving less real wealth to fund the maintenance and the expansion of the infrastructure.
Now, Fed officials give the impression that once they put the economy onto the so-called self-sustained growth path the removal of the monetary stimulus will not generate major side effects. But in reality a loose monetary policy sets in motion bubble activities. The existence of these activities is supported by monetary pumping, which diverts to bubble activities real wealth from wealth generating activities.
Once monetary pumping is aborted, bubble activities are forced to go under since they cannot fund themselves without the support of loose monetary policy. An economic bust ensues. The illusion that the Fed can bring the economy onto a self-sustaining growth path is shattered.
ConclusionOn account of a visible decline in the growth momentum of the US price index, many economists have concluded that this provides scope for the Fed to maintain its aggressive monetary stance. Some economists such as the president of the Chicago Federal Reserve Bank, Charles Evans, even argue that the declining trend in the growth momentum of the CPI makes it possible for the Fed to further strengthen monetary pumping. This, it is held, will reverse the declining trend in price inflation and will bring the US economy onto a path of healthy economic growth. We suggest that contrary to Evans, a strengthening in monetary pumping will only deepen economic impoverishment by allowing the emergence of new bubble activities and by the strengthening of existing bubble activities.
After the stock market collapse of 2008 and a decline of 3.4 percent for U.S. GDP in 2009, investors rushed to stash funds in emerging markets (EM) where economies were growing at a 3.1 percent annual rate. But the US stock market fell in January of this year largely due to financial trouble in emerging markets. The economies of EM nations, such as, Brazil, Russia, India, Turkey, Thailand, and China, have deteriorated in part because of the withdrawal of US dollar investments from them. Here is a chart from the Institute for International Finance (IIF)“Capital Flows to Emerging Market Countries,” IIF Research Notes, October 7, 2013, Institute of International Finance, p. 1, www.iff.org. showing the capital flows to EM nations:
This dynamic confirms the effects of monetary policy as described by the ABCT, the Austrian business cycle theory. The ABCT states that inflationary monetary policies, such as those of the Fed for the past five years, will cause an unsustainable boom as new money pours into the economy and stimulates demand for consumer goods and capital goods, increasing prices and the relative price of capital goods. Usually we think of the ABCT in terms of a single nation, but the EM problems demonstrate that it has international implications as well, especially in a world of increasing trade integration and a currency that other countries use for trade and their banks keep for reserves, such as the US dollar and the Euro.
Mises wrote about the international effects of banks creating more credit money than the domestic population wants to hold:
The role money plays in international trade is not different from that which it plays in domestic trade. Money is no less a medium of exchange in foreign trade than it is in domestic trade. Both in domestic trade and in international trade purchases and sales result in a more than passing change in the cash holdings of individuals and firms only if people are purposely intent upon increasing or restricting the size of their cash holdings. A surplus of money flows into a country only when its residents are more eager to increase their cash holdings than are the foreigners. An outflow of money occurs only if the residents are more eager to reduce their cash holdings than are the foreigners. A transfer of money from one country into another country which is not compensated by a transfer in the opposite direction is never the unintended result of international trade transactions. It is always the outcome of intended changes in the cash holdings of the residents. Just as wheat is exported only if a country's residents want to export a surplus of wheat, so money is exported only if the residents want to export a sum of money which they consider as a surplus. Ludwig von Mises, Human Action: A Treatise on Economics, Scholars Edition, (1998), p. 446.
What Mises wrote is backward to what mainstream economics and the financial media teach: trade in goods happen first then money follows to square the balances. While Mises wrote about international trade, the same principle applies to international investing. Just as consumers will buy imported goods (export money) if the Fed creates more money than US citizens want to hold, investors will “import” investment opportunities (export money for investment) if the Fed creates more new money than investors want to hold. As a result, the Fed exports its unsustainable boom, often to emerging market countries. That is one reason that the Fed monetary pump has not generated the higher price inflation in the US that the mainstream economists would like.
The export of US investment dollars to EM countries caused a boom in those economies, but the threat of reduced credit expansion by the Fed has brought turmoil. Of course, the Fed had done nothing but nip at the massive bond purchases by cutting back ten of 80 billion dollars in purchases per month. The Fed advertises that it will keep interest rates near zero indefinitely. That means that money flowing to emerging markets may increase in the future as the IIF forecasts. Eventually, the Fed will be forced to raise interest rates and at that time EM nations must pay the price. As Mises wrote:
One of the main objectives of currency devaluation — whether large-scale or small-scale — is ... to rearrange foreign trade conditions. These effects upon foreign trade make it impossible for a small nation to take its own course in currency manipulation irrespective of what those countries are doing with whom its trade relations are closest. Such nations are forced to follow in the wake of a foreign country’s monetary policies.
The emerging market situation reflects another aspect of the ABCT: most emerging market nations export commodities such as metals, food, coal, and oil. In the Austrian taxonomy, they produce higher order goods, consumer goods being the lower order. In another analogy, commodities are at the headwaters of the stream of production and flow through many transformations before becoming consumer goods. Commodities are much more sensitive to changes in the money supply because producing them requires capital intensive processes. Production is much more volatile than consumer goods.
A simplified taxonomy of the worldwide structure of production might categorize the US, Europe, and Japan as producers of capital goods intermediate between the higher order raw material producers of EM nations and the consumer goods producers such as China. This categorization is not clearly defined because most nations have several of the stages of production. Nevertheless, increasing integration has achieved a degree of international specialization in the capital structure. China tends to be a consumer goods producer while the US imports many consumer goods and raw materials for transformation into intermediate capital goods, such as aircraft, electrical generating equipment, and cars.
Internationally, the ABCT might work something like this: the Fed expands credit, and thereby the money supply, during a recession in order to stimulate domestic aggregate demand. But it creates more money than US citizens want to hold, so they buy more imported consumer goods from China and investments from EM countries. The export of investment funds causes the boom in the higher order phases of the capital structure in EM nations instead of the US where the Fed intended the funds to go.
Of course, Europe and Japan add to the world’s stock of reserve currencies and tend to expand credit in sync with the US, thereby multiplying the effects.
At some point, the Fed will begin to cut back on credit expansion in order to head off rising price inflation at home. Investors will repatriate their money from EM nations and cause a decline in the EM foreign exchange rate with respect to the dollar, yen, and euro. The IIF report from October warned that, “... other things equal, if market expectations for the U.S. policy interest rate were to rise from the current 1 percent at end-2015 to 2 percent, this could result in a retrenchment of EM portfolio flows of around $43 billion ...”IIF Research Notes, p. 6.
The sliding exchange rate will make debts by EM governments and businesses that are denominated in dollars and euros more difficult to repay and cause some bankruptcies. If EM nations try to defend their foreign exchange rate through higher interest rates to attract more investment, they make domestic borrowing more difficult and run the risk of exacerbating the business slump.
So EM nations face two problems at the same time: (1) the withdrawal of investment funds from the US and (2) a collapse in the demand for commodities as the boom ages and turns into a bust.
If only the Fed could see the damage it causes not just at home, but worldwide.
Some key US economic data shows visible weakening. The National Association of Home Builders/Wells Fargo sentiment index slumped to 46 in February from 56 in January.
The New York Federal Reserve Bank’s Empire State general business conditions index fell to 4.48 in February from 12.51 the month before.
Also, the yearly rate of growth of housing starts fell to minus 2 percent in January from 6.6 percent in the month before. Whilst the yearly rate of growth for existing home sales fell to minus 5.1 percent in January from minus 0.2 percent in December — the third consecutive month of negative growth.
Furthermore, the Philadelphia Fed business index fell to minus 6.3 in February from 9.4 in January.
Most economic commentators blame the weakening in economic data on bad weather conditions that have gripped much of the US. On this way of thinking the economy remains strong and short setbacks are on account of consumers and businesses putting off purchases. However, this should reverse, so it is held, once the weather improves.
There is no doubt that weather conditions can cause disruptions in economic activity. However, we hold that the recent weakening in the data could be in response to the emerging economic bust brought about by a decline in the growth momentum of money supply (see more details below).
Also, we suggest that the phenomena of recessions is not about the weakness of the economy as depicted by various economic indicators, but about the liquidation of various activities that sprang up on the back of the increase in the rate of growth of money supply. Here is why.
An increase in money supply sets in motion an exchange of nothing for something, which amounts to a diversion of real wealth from wealth generating activities to non-wealth generating activities. In the process this diversion weakens wealth generators and this in turn weakens their ability to grow the overall pool of real wealth (i.e., weakens their ability to grow the economy).
The expansion in the activities that sprang-up on the back of rising money supply is what an economic “boom," or false economic prosperity, is all about.
Note that once there is a strengthening in the pace of monetary expansion, irrespective of how strong and big a particular economy is, the pace of the diversion of real wealth is going to strengthen. Once, however, a slowdown in that pace of monetary expansion emerges, this slows down the diversion of real wealth from wealth producers to non-wealth producers.
This means that various bubble activities or non-productive activities are now getting less support from the money supply, and they fall into trouble.
A weakening in bubble activities is what a recession is all about. Irrespective of how big and strong an economy is, a decline in the rate of growth in money supply is going to undermine various uneconomic activities that sprang-up on the back of the previous increase in the money supply.
This means that recessions or economic busts have nothing to do with the so-called strength of an economy, improved productivity, or better inventory management by companies.
For instance, as a result of a loose monetary stance on the part of the Fed and the subsequent expansion in the money supply rate of growth various false activities emerge.
Now, even if these activities are well managed and maintain very efficient inventory control, this fact cannot be of much help once the central bank reverses its loose monetary stance. Again, these activities are the product of the loose monetary stance of the central bank. Once the stance is reversed, regardless of efficient inventory management, these activities will come under pressure and run the risk of being liquidated.
Having established that recessions are about the liquidations of unproductive activities, why are they recurrent? The reason for this is the central bank’s ongoing policies that are aimed at fixing the unintended consequences that arise from its earlier attempts at stabilizing the so-called economy.
On account of the time lags from changes in money to changes in economic activity the central bank or the Fed is forced to respond to the effects of its own previous monetary policies. These responses to the effects of past policies give rise to the fluctuations in the rate of growth of money supply and in turn to recurrent boom–bust cycles.
We suggest that a fall in the yearly rate of growth of AMS from 14.8 percnt in October 2011 to 8.1 percent in January 2014 poses a threat to various bubble activities that emerged on the back of an increase in the yearly rate of growth of AMS from 2.2 percent in June 2010 to 14.8 percent in October 2011.
Given the fact that there is a time lag between changes in money and changes in economic activity it is quite likely that the increase in the growth momentum of AMS during June 2010 to October 2011 is still dominating the economic scene.
As time goes by however, we suggest that a fall in the growth momentum of AMS during October 2011 to January 2014 can be expected to assert its dominance. This will be mirrored by the decline in bubble activities and in turn in various economic activity indicators.