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09/06/1998Jeff Scott

Milton Friedman, interviewed in Barron's (August 24, 1998), was asked:

Q: You were acquainted with the Austrian economist Friedrich Hayek and also are familiar with the work of Ludwig von Mises and his American disciple, Murray Rothbard. When you were talking about bad investments, you were alluding to Austrian business-cycle theory. There is a certain concept that has pretty much gone into our parlance and understanding, which fits in with what you said about what happened in Asia. There can be times and conditions in which the stage can be set for malinvestment that leads to recession.

Friedman Responds:

A: That is a very general statement that has very little content. I think the Austrian business-cycle theory has done the world a great deal of harm. If you go back to the 1930s, which is a key point, here you had the Austrians sitting in London, Hayek and Lionel Robbins, and saying you just have to let the bottom drop out of the world. You've just got to let it cure itself. You can't do anything about it. You will only make it worse. You have Rothbard saying it was a great mistake not to let the whole banking system collapse. I think by encouraging that kind of do-nothing policy both in Britain and the United States, they did harm.

He continues on to say "I don't think there are business cycles."

First, this response from Jeff Scott
Wells Fargo, San Francisco

Dear Editor:

Milton Friedman, in his interview with Gene Epstein (August 24, 1998) presents a caricature of the Austrian theory (and policy) of the business cycle, namely that Austrians are pleased to let the bottom fall out of the market when constructive corrective action is a plausible course.

In contrast to the Monetarist School, the Austrian School understands that economic upturns can be extended by the manipulation of credit and confidence. Central banks and Treasury departments create misleading signposts in the economy that channel capital into otherwise untenable investments.

Sharp downturns are a natural response to such systemwide malinvestments. Policymakers and central bankers best deal with recessions of this type--the bust of a phony investment boom--by letting prices go where they must. And if those levels are lower and lower than anybody in business and government can imagine, so be it.

Why should the appropriate economic policy be stalled by the pretense of imagination, or even worse, by a new inflationist policy?

Austrians emphasize the importance of allowing price discovery to fulfill its function and work toward restoring confidence. Ultimately, there are no artificial means of restoring confidence; they are all nativist boosterism in one form or another.

The lessons of current day Japan, suffering gross maladaptation, make this point rather clear. The unwillingness of their policymakers to allow prices to take their course has prolonged the misery for everyone.


Jeff Scott


The following article directly address Friedman's view of the Austrian cycle theory:

"Friedman's 'Plucking Model': Comment"

Economic Inquiry, vol. 34, no. 4 (October), 1996.

by Roger W. Garrison
Professor, Auburn University.
The author gratefully acknowledges the helpful comments from Milton Friedman, Thomas McQuade, Mark Skousen, Richard Vedder, Tom Willett, and two anonymous referees.


In a report on research in progress issued more than a quarter-century ago and again in a recent article consisting largely of excerpts from the earlier report, Milton Friedman [1969a; 1993] calls into question an entire class of business cycle theories which treat boom and subsequent bust as a logical and chronological sequence. He points to the Austrian theory of the business cycle as an example of the class of theories at odds with his own plucking model, which depicts the economy's output as falling (or being "plucked") below trend at random intervals and to various extents. In each episode of plucking, the return to trend mirrors the preceding fall, differing only by the underlying secular growth. Friedman [1993, 172] indicated decades ago that "If further substantiated empirically," the lack of boom-bust correlation "would cast grave doubt on those theories that see as a source of a deep depression the excesses of the prior expansion [the Mises cycle theory is a clear example]."1 More recently, he has claimed in an interview with Hammond [1992,102] that the "evidence [showing a zero correlation between boom and succeeding bust but a high correlation between boom and preceding bust] is decisive refutation of von Mises."


Austrians can question the decisiveness of this refutation on the basis of the different levels of aggregation employed by Friedman and by Mises. Monetarists report their findings in terms of the economy's total output, which includes the output of both the investment-goods sector and the consumer-goods sector. Although investment has long been recognized (by Monetarists and others) as being the more volatile, equilibrium forces are believed generally to prevail in both sectors as the economy moves along its growth path. But periods of presumably healthy economic growth are occasionally interrupted by an extramarket force, namely, an inept central bank that allows the money supply to contract relative to output. Real output is thus plucked loose from its trend. During the economy's temporary departure from trend, the outputs of both sectors move together, first down and then up. This temporal pattern of output, which involves no significant relative movements of investment and consumption, seems to justify the use of a single output aggregate.

In contrast, Austrians work at a lower level of aggregation in order to allow for the outputs of the two sectors to move relative to one another and even to allow for differential movements within the investment-goods sector. As envisioned early on by Menger [1981, 80-87] and developed by Hayek [1967, 32-68], the economy's production process is disaggregated into a number of temporally sequenced stages of production. The stages can be conceived in abstract terms as second, third, fourth, and n th order goods--with the higher orders denoting stages further removed in time from the emergence of consumer goods. For pedagogical concreteness, the different stages can be identified with particular kinds of activities: mining, for instance, is far removed from the consumption it will eventually make possible; retailing is in close temporal proximity to consumption.

Replacing the single investment aggregate with temporally sequenced stages that make up the economy's capital structure provides a basis for a substantive distinction between sustainable and unsustainable growth. Intertemporal equilibrium, as maintained by the rate of interest, requires a consistency between the allocation of resources among the various stages at any given point in time and the desired pattern of consumption over time. If reduced interest rates reflect a change in intertemporal consumption preferences, then the resulting reallocation of resources away from current consumption and toward investment--and from relatively low to relatively high stages of production--will eventually play itself out as a temporal shifting of consumption. This, apart from technological advance, is the essence of economic growth. If, by contrast, reduced interest rates reflect credit creation by the central bank, then the resulting process that governs the intertemporal allocation of resources will not play itself out but rather will do itself in. The capital-theoretic demonstration that a policy-induced boom contains the seeds of its own undoing constitutes the Austrian theory of the business cycle as first introduced by Mises [1953, 339-66]. Artificial booms inevitably end in busts.2

Taking account of the differing levels of aggregation, the data described by the plucking model are wholly consistent with the Austrian theory. The Austrians--and particularly Mises--were always insistent on using the term malinvestment instead of the more conventional overinvestment. During a credit-induced boom, investment in the relatively high stages of production is excessive in that resources are drawn away (by an artificially low rate of interest) from the relatively low stages of production and from the final stage, consumption. The decrease in the amount of resources allocated to the low and final stages is forced saving; the misallocation of resources from low to high stages is malinvestment. Empirically, a credit-induced boom would be but weakly reflected in the conventional investment aggregate and hardly at all in the Monetarists' output aggregate, which includes consumption. The boom for the Austrians refers to something going on largely within the output aggregate. It is represented in Friedman's plucking model not by a conspicuous recovery to trend but rather by some period preceding a pluck which Friedman, operating at a higher level of aggregation, presumes to be healthy growth.

Although Austrians and Monetarists are working at different levels of aggregation, they are dealing with the selfsame macroeconomy, as evidenced by each school's recognition of the movements of output that constitute the other's primary concern. Austrians recognize that the bust, which ends a period of credit-induced intertemporal disequilibrium, can affect the magnitude as well as the composition of the economy's output. The market process that liquidates the malinvestments is likely to involve complications--especially if the central bank behaves counterproductively--that result in a substantial reduction in total output. A self-aggravating, income-constrained process can entail an idling of capital and labor far in excess of that made necessary by the intertemporal disequilibrium. Hayek refers to this spiraling downward of demand in all stages, as distinguished from the reallocation of resources among the stages, as a "secondary deflation" [Bellante and Garrison, 1988, 229].

Monetarists hint at the relevance of resource movements within the output aggregate in specific episodes in which the real rate of interest is abnormally high on the eve of the bust. Referring to the period following October 1979, when the Federal Reserve had turned its attention from interest rates to monetary aggregates, Friedman claimed in an interview with Brimelow [1982, 6] that the business community had entered into "commitments" on the basis of the monetary expansion that began in April 1980. When the expansion ended a year later, these commitments had effects of their own. There was "a great deal of distress borrowing,...which has served to keep short-term real interest rates very high." Although the terms "commitment" and "distress borrowing" make no showing in Friedman's plucking model, they have a natural home in the Austrians' account of boom and bust.3

The overcommitment of resources to early stages of production, the distress borrowing associated with the (ultimately unsuccessful) attempt to finance the completion of these production projects, and finally the secondary deflation that may greatly magnify the resource idleness during the adjustment period are all consistent with the plucking model. Thus, even strong empirical support for plucking, if based upon the output aggregate, would not rule out boom-bust theories. Quite to the contrary, the Austrian theory offers special insights as to how a boom-bust market process can leave a trail of bust-boom aggregates.


Friedman's empirical findings are broadly consistent with both Monetarist and Austrian views. These two schools are not best distinguished in terms of the former's identification of broad-based macroeconomic regularities and the latter's unwillingness to recognize the significance of these empirical truths. They differ, rather, in their views of the market process that translates changes in money and credit into changes in prices and quantities. In the long run, the central bank has no control over real magnitudes, but there is a long and variable lag between initial and subsequent applications of the comparative-statics equation of exchange. The Monetarists have often issued disclaimers concerning the market process that eventually translates a monetary injection into an increase in the overall price level. "We [Friedman and Schwartz, 1969, 222] have little confidence in our knowledge of the transmission mechanism, except in such broad and vague terms as to constitute little more than an impressionistic representation rather than an engineering blueprint." Friedman [1987, 17; 1992, 49] reaffirms this theoretical lacking in his retrospective. Citing himself and others, he notes that "A major unsettled issue is the short-run division of a change in nominal income between output and prices. The division has varied widely over space and time and there exists no satisfactory theory that isolates the factors responsible for the variability." The Monetarists' "long and variable lag" is the Austrians' "substantial scope for intertemporal disequilibrium." The Austrian theory of the business cycle does not fly in the face of plucking but rather contributes--along with Friedman's own short-run/long-run Phillips curve analysis--to our understanding of the transmission mechanism.

Both early and recent empirical work has provided some support for Austrian views of boom and bust.4 Austrian theory suggests that tests involving movements in output magnitudes must be formulated at a suitably low level of aggregation. The thorny issues of capital theory, however, make direct testing difficult. One testable implication of the malinvestment that characterizes an unsustainable boom is the distress borrowing and hence the high real rates of interest on the eve of the bust. Charles Wainhouse [1984, 64] uses Granger causality tests to show that movements in interest rates and relative prices during the 1960s and 1970s are consistent with the hypothesis that at the end of the boom "the prices of consumer goods rise relative to the prices of producers' goods, reversing the initial shift in relative prices."5

Further empirical work inspired by plucking should maintain a clear distinction between Friedman's boom (recovery to trend) and Mises' boom (credit-induced malinvestment). It should also recognize that distress borrowing, which characterizes the natural end of a credit-induced boom, can also result from an exogenous credit contraction. But even in advance of further testing, we can reject Friedman's decisive refutation: Plucking describes the economy's performance at the highest level of aggregation; Austrian theory offers an insightful account of the market process that might underlie those aggregates.

  • 1. The bracketed reference to Mises was added in 1993.
  • 2. Friedman's own boom-bust theorizing--in the form of short-run/long-run Phillips curve analysis--can be seen as complementing the Austrian theory of the business cycle. The differences between the two theories stem largely from the fact that Mises, influenced by Böhm-Bawerk's theory of capital and interest, focused on the allocation of resources within capital markets as guided by the bank rate as opposed to the natural rate of interest, while Friedman, influenced by Frank Knight's critique of Böhm-Bawerk, focused on the actual as opposed to the natural level of employment as guided by the employers' and the employees' perceptions of the real wage rate. Taking a broad perspective, Bellante and Garrison [1988] argue that Mises' capital-market dynamics and Friedman's labor-market dynamics are complementary aspects of the boom-bust cycle.
  • 3. Friedman [1969b, 255-56] draws on Austrian ideas again when explaining the long and variable lag that separates monetary expansion and price inflation: Monetary expansion affects the demand for "equities, houses, durable producer goods, durable consumer goods, and so on.... The effects can be described as operating on 'interest rates,' if a more cosmopolitan [i.e. Austrian] interpretation of 'interest rate' is adopted than the usual one which refers to a small range of marketable securities.... But [subsequent countermovements] tend to...undo the initial effects on interest rates."
  • 4. Early work by Frederick C. Mills [1936] of the National Bureau of Economic Research focused on four temporally distinct subaggregates (raw materials, manufacturing, wholesaling, and retailing) and showed that movements in prices associated with these subaggregates are consistent with the Austrian theory: Temporal remoteness from consumption positively affects the interest-rate sensitivity of prices. Most recently, Butos [1993] found (weak) support for the Austrian theory using data on interest rates and bank credit from the 1980s bull market.
  • 5. This hypothesis, which deals the interest rate in Friedman's "cosmopolitan" sense, is one of several derived from Hayek's formulation of the Austrian theory and supported by the data. Testing failed to reject this hypothesis for the periods 1964-67 and 1977-80.
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Bellante, Don and Roger W. Garrison. "Phillips Curves and Hayekian Triangles: Two Perspectives on Monetary Dynamics." History of Political Economy, Summer 1988, 207-34.

Brimelow, Peter. "Talking Money with Milton Friedman." Barron's, 25 October 1982, 6-7.

Butos, William N. "The Recession and Austrian Business Cycle Theory: An Empirical Perspective." Critical Review, Spring-Summer 1993, 277-306.

Friedman, Milton. "Monetary Studies of the National Bureau," in idem. The Optimum Quantity of Money and Other Essays. Chicago: Aldine, 1969a, 261-84 [originally published, 1964].

__________. "The Lag Effect of Monetary Policy," in idem. The Optimum Quantity of Money and Other Essays. Chicago: Aldine, 1969b, 237-60.

__________. "The Quantity Theory of Money," in The New Palgrave: A Dictionary of Economics, edited by J. Eatwell, M. Milgate, and P. Newman. London: Macmillan Press, Ltd., 1987, 3-20.

__________. Money Mischief: Episodes in Monetary History. New York: Harcourt Brace Jovanovich, 1992.

__________. "The 'Plucking Model' of Business Cycle Fluctuations Revisited." Economic Inquiry, April 1993, 171-77.

Friedman, Milton and Anna J. Schwartz. "Money and Business Cycles," in M. Friedman. The Optimum Quantity of Money and Other Essays. Chicago: Aldine, 1969, 189-235 [originally published, 1963].

Hammond, J. Daniel. "An Interview with Milton Friedman on Methodology." The History of Economic Thought and Methodology 10, 1992, 91-118.

Hayek, Friedrich A. Prices and Production. 2nd ed. New York: Augustus M. Kelley, 1967 [originally published, 1935].

Menger, Carl. Principles of Economics. New York: New York University Press, 1981 [originally published, 1871].

Mills, Frederick. C. Prices in Recession and Recovery. New York: National Bureau of Economic Research, 1936.

Mises, Ludwig von. The Theory of Money and Credit. New Haven: Yale University Press, 1953 [originally published, 1912].

Wainhouse, Charles. "Empirical Evidence for Hayek's Theory of Economic Fluctuations," in Money in Crises: The Federal Reserve, the Economy, and Monetary Reform, edited by B. Siegel. Cambridge, MA: Ballinger, 1984, 37-71.