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The Austrian Theory of the Trade Cycle
Compiled by Richard M. Ebeling

Introduction: The Austrian Theory in Perspective


Roger W. Garrison

The four essays in this volume, each written by a major figure in the Austrian school of economics, set out and apply a distinctive theory of the business cycle. The span of years (1932-1970) over which they appeared saw a dramatic waxing and then waning of the prominence--both inside and outside the economics profession--of the Austrian theory. Gottfried Haberler wrote in his 1932 essay that the theory "is not so well known in this country as it deserves to be" (pp. 44). Although Ludwig von Mises offered no assessment in this regard in his essay, he remarked in 1943 about the effect of the theory's general acceptance on the actual course of the cycle. Anticipating a key insight in the modern literature on "rational expectations," Mises wrote, "The teachings of the monetary theory of the trade cycle are today so well known even outside the circle of economists that the naive optimism which inspired the entrepreneurs in the boom periods has given way to greater skepticism." [1] Then, in 1969, Murray N. Rothbard could write--without serious overstatement--that "a correct theory of depressions and of the business cycle does exist, even though it is universally neglected in present-day economics" (p. 74).

What happened over the span of nearly forty years to account for the rise and fall of this theory of boom and bust? The simple answer, of course, is: the Keynesian revolution. John Maynard Keynes's General Theory of Employment, Interest, and Money, which made its appearance in 1936, produced a major change in the way that economists deal with macro-economic issues. A close look at some pre-Keynesian ideas can show why the Austrian theory was so easily lost in the aftermath of the Keynesian revolution; a brief survey of the alternatives offered by modern macroeconomics will show why there is a new-found interest in this old Austrian theory.

First introduced by Mises in his Theory of Money and Credit (1912), the theory was originally billed as the circulation credit theory rather than as a uniquely Austrian theory. Mises was very much aware of its multinational roots. The notion that the market process can be systematically affected by a divergence between the bank rate of interest and the natural rate came from Swedish economist Knut Wicksell; the understanding that the process so affected would have a self-reversing quality to it (Mises used the term "counter-movements" in his earliest exposition) came from the British currency school, whose analysis featured international gold flows. The uniquely Austrian element in Mises's formulation is the capital theory introduced by Carl Menger and developed by Eugen von Boehm-Bawerk. Mises showed that an artificially low rate of interest, maintained by credit expansion, misallocates capital, making the production process too time-consuming in relation to the temporal pattern of consumer demand. As time eventually reveals the discrepancy, markets for both capital goods and consumer goods react to undo the misallocation. The initial misallocation and eventual reallocation constitute the microeconomic foundations that underlie the observed macroeconomic phenomenon of boom and bust. Mises's theory was superior to its Swedish forerunner in that Wicksell was concerned almost exclusively with the effect of credit expansion on the general level of prices. It was superior to its British forerunner in that the currency school's theory applied only when monetary expansion in one country outpaced that of its trading partners. Mises's theory was applicable even to a closed economy and to a world economy in which all countries are experiencing a credit expansion.

The theory took on a more predominantly Austrian character in the hands of F. A. Hayek. In the late 1920s and early 1930s, Hayek gave emphasis to the Austrian vision of capital that underlies the business cycle theory by introducing a simple graphical representation of the structure of production. He used right triangles that change in shape to illustrate a change in the economy's capital structure. [2] Hayek focused the analysis clearly on the relationship between the roundaboutness of the production process and the value of the corresponding output. The Hayekian triangles keep track of both time and money as goods-in-process make their way through the temporally sequenced stages of production. His notion of a linear production process is highly abstract and overly simple in the light of a fuller accounting of the fixed and circulating capital that actually characterize a capital-using economy. However, these triangles feature an essential but often neglected dimension--the time dimension--in the account of boom and bust. Alternative theories, in which consumption and investment appear as two coexisting aggregates, can be seen as even more simplistic--to the point of being wholly inadequate for analyzing the boom-bust sequence.

Haberler concludes his essay with an expression of concern about the complexity of the Austrian theory, which he saw as a "serious disadvantage" (p. 64). But the complexity, in his judgment, is inherent in the subject matter and hence is not a fault of the theory. Complexity is evident in the two early essays (1936 and 1932) in their organization and style of argument. Both Mises and Haberler defend the theory against its critics and deal with various misunderstandings. Mises, for instance, identifies Irving Fisher's inflation premium, which attaches itself to the rate of interest as prices in general rise, only to say that this is not what he is talking about. He is discussing, instead, still another aspect of interest-rate dynamics. The real rate of interest rises at the end of the boom to reflect the increasing scarcity of circulating capital, after excessive amounts of capital have been committed to the early stages of production processes (p. 31). Haberler takes great pains to refocus the reader's attention away from the general price level and toward the relative prices that govern the "vertical structure of production" (p. 49). He distinguishes between "absolute deflation" and "relative deflation," and between "primary and fundamental" phenomena that characterize the downturn and "secondary and accidental" phenomena that may also be observed. All these complexities--plus still others involving such notions as the natural rate of interest and the corresponding degree of roundaboutness of the production process--are unavoidable in a theory that features an intertemporal capital structure. The theoretical richness that stems from the attention to capital has as its negative counterpart the expositional difficulties and scope for misunderstanding.

Keynes offered the profession relief from all this by articulating--though cryptically--a capital-free macroeconomics. As Rothbard's discussion implies, all the thorny issues of capital theory were simply swept aside. An alternative theory that featured the playoff between incomes and expenditures left little or no room for a capital structure. Investment was given special treatment not because of its link to future consumption but because spending on investment goods is particularly unstable. Uncertainties, which are perceived to be a deep-seated feature of market economies, dominate decision making in the business community and give play to psychological explanations of prosperity and depression. And the notion that depression may be attributable to pessimism on the part of the business community suggests a need for central direction and policy activism. Prosperity seems to depend upon strong and optimistic leadership in the political arena. Relief from the complexities of capital theory together with policy implications that were exceedingly attractive to elected officials gave Keynesianism an advantage over Austrianism. An easy-to-follow recipe for managing the macroeconomy won out over a difficult-to-follow theory that explains why such management is counterproductive.

Tellingly, the two later essays (1969 and 1970) are as much about Keynesianism as about Austrianism. Rothbard and Hayek are trying anew to call attention to a theory that had been buried for decades under the Keynesian avalanche. Rothbard deals with the Phillips curve, which purports to offer a choice to political leaders between inflation and unemployment; Hayek deals with the wage-price spiral, which had captured the attention of journalists and textbook authors for much of the postwar era. The need for dealing critically with Keynesianism--and with monetarism--while at the same time reintroducing the key considerations from capital theory meant that the Austrian theory of the business cycle was an even harder sell in the 1970s than it had been a half-century earlier.

The offering of these four separate and distinct essays on the Austrian theory carries the message that there is no single canonical version of the theory. Our understanding of boom and bust is not based upon some pat story to be told once and for all time. Rather, the theory allows for variations on a theme. The market works; it tailors production decisions to consumption preferences. But production takes time, and as the economy becomes more capital intensive, the time element takes on greater significance. The role of the interest rate in allocating resources over time becomes an increasingly critical one. Still, if the interest rate is right, that is, if the interplay between lenders and borrowers is allowed to establish the natural rate, then the market works right. However, if the interest rate is wrong, possibly because of central bank policies aimed at "growing the economy," then the market goes wrong. The particulars of just how it goes wrong, just when the misallocations are eventually detected, and just what complications the subsequent reallocation might entail are all dependent on the underlying institutional arrangements and on the particular actions of policy makers and reactions of market participants.

The essays leave much scope for solving puzzles, for refining both theory and exposition, and for applying the theory in different institutional and political environments. One enduring puzzle emerges from the writings of several economists, including Haberler, who once embraced the theory enthusiastically but subsequently rejected it. The key question underlying the recantations is easily stated: Can the intertemporal misallocation of capital that occurs during the boom account for the length and depth of the depression? Haberler provides one of the best answers to this question--one that is most favorable to the Austrian theory--in his 1932 essay. The "maladjustment of the vertical structure of production," to use Haberler's own term, does not, by itself, account for the length and depth of the depression. Rather, this policy-induced change in the intertemporal structure of capital is the basis for the claim that a crisis and downturn are inevitable. The reallocation of resources that follows the downturn, which largely mirrors--both qualitatively and quantitatively--the earlier misallocation, involves an abnormally high level of (structural) unemployment but need not involve a deep and lengthy depression.

However, complications that may well accompany the market's adjustment to a policy-induced intertemporal misallocation can cause the depression to be much deeper and longer than it otherwise would be. The same policy makers who orchestrated the artificial boom may well behave ineptly when they see that the ultimate consequence of their policy is a bust. Their failure to stem the monetary contraction together with interventions by the legislature that prop up prices and wages and strengthen trade barriers will make a bad situation worse. All such complications, which play themselves out as a self-aggravating contraction, are correctly identified by Haberler as "secondary phenomena." This term is not employed to suggest that these aspects of the depression are negligible or second-order in importance. "[I]t may very well be," Haberler explains, "that this secondary wave of depression, which is induced by the more fundamental maladjustment, will grow to an overwhelming importance" (p. 58). Though possibly overwhelming, the effects of the complications are still secondary in the sense of temporal and causal ordering.

The puzzle in all this emerges when we read Haberler's 1976 recantation of the Austrian theory, which echoed Lionel Robbins's heartfelt recantation of a few years earlier. Mises refers to Robbins's 1934 book, The Great Depression, as "the best analysis of the actual crisis" (p. 28 n). In 1971 Robbins wrote in his autobiography that this is a book "which [he] would willingly see forgotten." [3] Drawing on Robbins's recantation, Haberler offers the opinion that the "real maladjustments, whatever their nature, were completely swamped by vast deflationary forces.'" But rather than suggest, as he had earlier, that these forces could easily have been "induced by the more fundamental maladjustments," he simply attributes them to "institutional weaknesses and policy mistakes." [4] The astute reader will see Haberler's 1932 discussion of secondary phenomena as an insightful and hard-hitting critique of the 1976 Haberler--and would see a similar relationship between the 1934 Robbins and the 1971 Robbins.

In 1932, Haberler alluded to the "economic earthquakes" (p. 37) that Western countries had experienced. He might have put the earthquake metaphor to further use in accounting for the relationship between primary and secondary issues. During the 1906 earthquake in San Francisco, for instance, fires broke out and caused much more destruction than had been caused by the actual quaking of the earth. Even so, the fire was a secondary phenomenon; the quake was the primary phenomenon. The fact that the length and depth of the Great Depression are to be accounted for largely in terms of secondary phenomena, then, does not weigh against our understanding that the primary phenomenon was the quaking of the capital structure. What accounts, then, for the recantation of these Austrian theorists--and of several others, including John R. Hicks, Nicholas Kaldor, and Abba P. Lerner? This puzzle remains to be solved.

Expositional difficulties derive largely from the fact that the capital-based macroeconomics of the Austrian school and particularly the Austrian theory of the business cycle are foreign to modern economists whose training is exclusively in labor-based macroeconomics. In today's profession, a given capital stock has become one of the defining assumptions underlying the conventional macroeconomic relationships. To allow capital to be a variable rather than a parameter is to change the subject matter--from macroeconomics to the economics of growth. Further, modern economists tend to think of capital holistically in terms of stocks and flows, which precludes any consideration of changes--to say nothing of unsustainable changes--in the capital structure. Gordon Tullock's bafflement at the Austrian theory is illuminating in this regard. Tullock takes Rothbard's essay as canonical and explains "Why the Austrians Are Wrong about Depressions." This article, together with a comment by Joseph T. Salerno and reply by Tullock, merit careful study. [5] According to Tullock's understanding of the Austrian theory, the boom is a period during which the flow of consumer goods is sacrificed so that the capital stock can be enlarged. At the end of the boom, then, the capital stock would actually be larger, and the subsequent flow of consumer goods would be correspondingly greater. Therefore, the period identified by the Austrians as a depression would, instead, be a period marked by increased employment (labor is complementary to capital) and a higher standard of living. The stock-flow construction that underlies this line of reasoning does not allow for the structural unemployment that characterizes the crisis--much less for the complications in the form of the secondary depression. [6] This exchange between Tullock and Salerno gives the modern student of Austrianism a good feel for the challenge involved in the exposition of Austrian theory in an academic environment unreceptive to a capital-based macroeconomics.

Capital-based macroeconomics is simply macroeconomics that incorporates the time element into the basic construction of the theory. Investment now is aimed at consumption later. The interval of time that separates this employment of means and the eventual achievement of ends is as fundamental a variable as are the more conventional ones of land and labor. The Austrian theory features the time element by showing what happens when the economy's production time, the degree of roundaboutness, is thrown out of equilibrium by policies that override the market process. Beyond this general understanding, as already suggested, the focus of particular expositions vary in accordance with the historical and institutional setting. The fact that each of the essays in this volume reflects its own time and setting does not imply a myopia on the part of its author. Rather, it suggests the versatility of the theory.

Writing in the early 1930s, for instance, Mises called attention to the "flight into real values" (p. 30) that characterizes a hyperinflation, such as the one experienced in Germany in 1923. The lesson, though, transcends the insights into that particular historical experience. If, over a period of years, capital has been misallocated by an accelerating credit expansion, there is no policy that avoids a crisis. In the modern vernacular, there is no possibility of a "soft landing." [7] Decelerating the expansion will cause real interest rates to rise dramatically as credit becomes increasingly scarce; bankruptcies would follow. Further accelerating the expansion will cause hyperinflation and a collapse of the monetary system. Mises is telling us, in effect, that the central bank can print itself into trouble, but it cannot print itself out of trouble. Writing in 1970, Hayek refers to the central bank's dilemma by suggesting that on the eve of the crisis the policy makers find themselves "holding a tiger by the tail." He gives play to the political and economic forces that were then dominant by relating them to the commonly perceived wage-price spiral that accompanies a prolonged expansion. The final throes of the boom take the form of a duel between labor unions, which have the political power to force wage rates higher, and the central bank, which can bring them back down (in real terms) by accelerating the rate of inflation. Although Hayek, above all others, is to be credited with shifting the focus of business cycle theory from labor markets to capital markets, he offers few clues in this essay about disequilibrium in the intertemporal structure of production. Instead, he recognizes that the political and economic dynamics of the period have given special relevance to the problem--he even calls it the "central problem" (p. 110)--of wage determination.

The application of the Austrian theory of the business cycle in today's economy would give little play to the fear of hyperinflation or to the problem of a wage-price spiral. The central problem today is chronic and dramatic fiscal imbalance. Budget deficits rather than credit expansion are bound to be the focus in any plausible account of the effect of the government's macroeconomic policy on the economy's performance. Still, the central bank figures importantly into the story. The very potential for monetizing the Treasury's debt eliminates the risk of default, and thereby puts the Treasury on a much longer leash than it would otherwise enjoy. The problem of an artificially low rate of interest in earlier episodes is overshadowed by the problem of an artificially low risk premium on government debt. Although risk-free to the holders of Treasury securities, this black cloud of debt overhangs the market for private securities, distorting the economy's capital structure and degrading its performance generally. There are some modern applications of the Austrian theory that take these considerations into account, but much remains to be done. [8]

A stocktaking of the modern alternatives to the Austrian theory suggests that capital-based macroeconomics may be due for a comeback. Conventional Keynesianism, whether in the guise of the principles-level Keynesian cross, the intermediate IS-LM, or the advanced AS/AD is formulated at a level of aggregation too high to bring the cyclical quality of boom and bust into full view. Worse, the development of these tools of analysis in the hands of the modern textbook industry has involved a serious sacrifice of substance in favor of pedagogy. Students are taught about the supply and demand curves that represent the market for a particular good or service, such as hamburgers or haircuts. Then they are led into the macroeconomic issues by the application of similar-looking supply and demand curves to the economy as a whole. The transition to aggregate supply and aggregate demand, which is made to look deceptively simple, hides all the fundamental differences between microeconomic issues and macroeconomic issues. While these macroeconomic aggregates continue to be presented to college undergraduates, they have fallen into disrepute outside the classroom. One recent reconsideration of the macroeconomic stories told to students identifies fundamental inconsistencies in AS/AD analysis. [9]

Conventional monetarism employs a level of aggregation as high as, if not higher than, that employed by Keynesianism. While Milton Friedman is to be credited with having persuaded the economics profession--and much of the general citizenry--of the strong relationship between the supply of money and the general level of prices, his monetarism adds little to our understanding of the relationship between boom and bust. The monetarists have effectively countered the Keynesians on many fronts, but they share with them the belief that macroeconomics and even business cycle theory can safely ignore all considerations of a capital structure. Modern spin-offs of monetarism, which incorporate the ideas of rational expectations and instantaneous market clearing, have brought the time element back into play. Overlapping-generations models and particularly the time-to-build models seem to have some relationship to Austrian ideas. But the emphasis on the development of modeling techniques over the application of the theory to actual episodes of boom and bust has greatly diminished the relevance of this strand of macroeconomic thought. [10]

In recent years, there has been an increasingly widespread recognition that modern macroeconomics is in disarray. Today's textbooks and professional journals are replete with models that, while impressive in their display of technique, are profoundly implausible and wholly inapplicable to the world as we know it. The inadequacies of modern macroeconomics have caused some academicians to wonder (if only facetiously): How far back do we have to go before we can start all over? The essays in this volume provide a substantive answer to that question. We have to go back about sixty years to a time when capital theory was an integral part of macroeconomics. We have to go back to the Austrian school. A modernized capital-based macroeconomics can compare favorably with any of the present-day rivals.

Murray Rothbard's essay ends with an anticipation of the Austrian revival--which actually began, with his help, in 1974. This volume is offered in the spirit of Rothbard and in the hope that the Austrians will have an increasing influence in the years ahead on the development of business cycle theory.

[1] Ludwig von Mises, "Elastic Expectations and the Austrian Theory of the Trade Cycle," Economica, ns. 10 (August 1943): 251.

[2] Friedrich A. Hayek, Prices and Production, 2nd ed. (New York: Augustus M. Kelley, 1935).

[3] Lionel Robbins, An Autobiography of an Economist (London: Macmillan, 1971),p. 154.

[4] Gottfried Haberler, The World Economy, Money, and the Great Depression 1919-1939 (Washington, D.C.: American Enterprise Institute, 1976), p. 26. Also see Haberler, "Reflections on Hayek's Business Cycle Theory," Cato Journal 6, no 2 (Fall 1986): 421-35.

[5] Gordon Tullock, "Why the Austrians Are Wrong About Depressions" Review of Austrian Economics 2 (1987): 73-78; Joseph T. Salerno, Comment on Tullock's "Why Austrians Are Wrong About Depressions" Review of Austrian Economics 3 (1989): 141-45; and Tullock, "Reply to Comment by Joseph T. Salerno" Review of Austrian Economics 3 (1989): 147-49.

[6] Tullock on the basis of a peculiar judgment about the relative size of the economy's producer goods sector, makes a minor concession to the Austrian theory: It applies to "those factories and machine tools that were less than 40 percent completed [at the end of the boom]." But, "the producer goods industries are always a fairly small part of the economy. In that small part, however, undeniably a Rothbard, Austrian type of depression would cause a cutback in production and laying off of personnel."

[7] This is not to deny the difference between a hard landing with no complications and a crash, in which the complications dominate.

[8] Roger W. Garrison, "Hayekian Triangles and Beyond," in Jack Birner and Rudy van Zijp, eds., Hayek, Coordination and Evolution (London: Routledge, 1994), pp.109-25; and Roger W. Garrison, ""The Federal Reserve: Then and Now" Review of Austrian Economics 8, no. 1 (1994): 3-19.

[9] David Colander, "The Stories We Tell: A Reconsideration of AS/AD Analysis," Journal of Economic Perspectives 9, no. 3 (Summer 1995): 169-88.

[10] On the relationship between new classical theory and Austrian theory, see Kevin Hoover, "An Austrian Revival?" in Hoover, The New Classical Macroeconomics: A Skeptical Inquiry (Cambridge: Basil Blackwell, 1988), pp. 231-57; and Roger W. Garrison, "New Classical and Old Austrian Economics: Equilibrium Business Cycle Theory in Perspective" Review of Austrian Economics 5, no. 1 (1991): 91-103.

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