Archive for the 'Ludwig von Mises' Category

Central Banking and the Real-Bills Doctrine

Published December 8, 2023 Adam Smith , D. H. Robertson , gold standard , Great Depression , Lloyd Mints , Ludwig von Mises , Milton Friedman , quantity theory of money , real-bills doctrine , Richard Timberlake , Robert Hetzel , Thomas Humphrey , Uncategorized 9 Comments

            Robert Hetzel, a distinguished historian of monetary theory and of monetary institutions, deployed his expertise in both fields in his recent The Federal Reserve: A New History. Hetzel’s theoretical point departure is that the creation of the Federal Reserve System in 1913 effectively replaced the pre-World War I gold standard, in which the value of the dollar was determined by the value of gold into which a dollar was convertible at a fixed rate, with a fiat-money system. The replacement did not happen immediately upon creation of the Fed; it took place during World War I as the international gold standard collapsed with all belligerent countries suspending the convertibility of their currencies into gold, to allow the mobilization of gold to finance imports of food and war materials. As a result, huge amounts of gold flowed into the US, where of much of those imports originated, and continued after the war when much of the imports required for European reconstruction also originated there, with the US freely supplying dollars in exchange for gold at the fixed price at which the dollar was convertible into gold, causing continued postwar inflation beyond the wartime inflation.

Holding more than half the world’s total stock of monetary gold reserves by 1920, the US could determine the value of gold at any point (within a wide range) of its own choosing. The value of the dollar was therefore no longer constrained by the value of gold, as it had been under the prewar gold standard, because the value of gold was now controlled by the Federal Reserve. That fundamental change was widely acknowledged at the time by economists like Keynes, Fisher, Robertson, Mises, and Hawtrey. But the Fed had little understanding of how to exercise that power. Hetzel explains the mechanisms whereby the power could be exercised, and the large gaps and errors in the Fed’s grasp of how to deploy the mechanisms. The mechanisms were a) setting an interest rate at which to lend reserves (by rediscounting commercial bank assets offered as collateral) to the banking system, and b) buying or selling government securities and other instruments like commercial paper (open-market operations) whereby reserves could be injected into, or withdrawn from, the banking system.

In discussing how the Fed could control the price level after World War I, Hetzel emphasizes the confusion sewed by the real-bills doctrine which provided the conceptual framework for the architects of the Federal Reserve and many of its early officials. Hetzel is not the first to identify the real-bills doctrine as a key conceptual error that contributed to the abysmal policy mistakes of the Federal Reserve before and during the Great Depression. The real-bills doctrine has long been a bete noire of Chicago School economists, (see for example the recent book by Thomas Humphrey and Richard Timberlake, Gold, the Real Bills Doctrine and the Fed), but Chicago School economists since Milton Friedman’s teacher Lloyd Mints have misunderstood both the doctrine (though not in the same way as those they criticize) because they adopt a naive view of the quantity theory the prevents them from understanding how the gold standard actually worked.

Long and widely misunderstood, the real-bills doctrine was first articulated by Adam Smith. But, as I showed in a 1992 paper (reprinted as Chapter 4 of my recent Studies in the History of Monetary Theory), Smith conceived the doctrine as a rule of thumb to be followed by individual banks to ensure that they had sufficient liquidity to meet demands for redemption of their liabilities (banknotes and deposits) should the demand for those liabilities decline. Because individual banks have no responsibility, beyond the obligation to keep their redemption commitments, for maintaining the value of their liabilities, Smith’s version of the real-bills doctrine was orthogonal to the policy question of how a central bank should discharge a mandate to keep the general price level reasonably stable.

Not until two decades after publication of Smith’s great work, during the Napoleonic Wars that confusion arose about what the real-bills doctrine actually means. After convertibility of the British pound into gold was suspended in 1797 owing to fear of a possible French invasion, the pound fell to a discount against gold, causing a general increase in British prices. The persistent discount of the pound against gold was widely blamed on an overissue of banknotes by the Bank of England (whose notes had been made legal tender to discharge debts after their convertibility into gold had been suspended. The Bank Directors responded to charges of overissue by asserting that they had strictly followed Smith’s maxim of lending only on the security of real bills of short duration. Their defense was a misunderstanding of Smith’s doctrine, which concerned the conduct of a bank obligated to redeem its liabilities in terms of an asset (presumably gold or silver) whose supply it could not control, whereas the Bank of England was then under no legal obligation to redeem its banknotes in terms of any outside asset.

Although their response misrepresented Smith’s doctrine, that misrepresentation soon became deeply imbedded in the literature on money and banking. Few commentators grasped the distinction between the doctrine applied to individual banks and the doctrine applied to the system as a whole or to a central bank issuing a currency whose value it can control.

The Bank Directors argued that because they scrupulously followed the real-bills doctrine, an overissue of banknotes was not possible. The discount against gold must therefore have been occasioned by some exogenous cause beyond the Bank’s control. This claim could have been true only in part. Even if the Bank did not issue more banknotes than it would have had convertibility not been suspended, so that the discount of the pound against gold was not necessarily the result of any action committed by the Bank, that does not mean that the Bank could not have prevented or reversed the discount by taking remedial or countervailing measures.

The discount against gold might, for example, have occurred, even with no change in the lending practices of the Bank, simply because public confidence in the pound declined after the suspension of convertibility, causing the demand for gold bullion to increase, raising the price of gold in terms of pounds. The Bank could have countered such a self-fulfilling expectation of pound depreciation by raising its lending rate or otherwise restricting credit thereby withdrawing pounds from circulation, preventing or reversing the discount. Because it did not take such countermeasures the Bank did indeed bear some responsibility for the discount against gold.

Although it is not obvious that the Bank ought to have responded in that way to prevent or reverse the discount, the claim of the Bank Directors that, by following the real-bills doctrine, they had done all that they could have done to avoid the rise in prices was both disingenuous and inaccurate. The Bank faced a policy question: whether to tolerate a rise in prices or prevent or reverse it by restricting credit, perhaps causing a downturn in economic activity and increased unemployment. Unwilling either to accept responsibility for their decision or to defend it, the Bank Directors invoked the real-bills doctrine as a pretext to deny responsibility for the discount. An alternative interpretation would be that the Bank Directors’ misunderstanding of the situation they faced was so comprehensive that they were oblivious to the implications of the policy choices that an understanding of the situation would have forced upon them.

The broader lesson of the misguided attempt by the Bank Directors to defend their conduct during the Napoleonic Wars is that the duty of a central bank cannot be merely to maintain its own liquidity; its duty must also encompass the liquidity and stability of the entire system. The liquidity and stability of the entire system depends chiefly on the stability of the general price level. Under a metallic (silver or gold) standard, central banks had very limited ability to control the price level, which was determined primarily in international markets for gold and silver. Thus, the duty of a central bank under a metallic standard could extend no further than to provide liquidity to the banking system during the recurring periods of stress or even crisis that characterized nineteenth-century banking systems.

Only after World War I did it become clear, at least to some economists, that the Federal Reserve had to take responsibility for stabilizing the general price level (not only for itself but for all countries on the restored gold standard), there being no greater threat to the liquidity—indeed, the solvency—of the system than a monetarily induced deflation in which bank assets depreciate faster than liabilities. Unless a central bank control the price level it could not discharge its responsibility to provide liquidity to the banking system. However, the misunderstanding of the real-bills doctrine led to the grave error that, by observing the real-bills doctrine, a central bank was doing all that was necessary and all that was possible to ensure the stability of the price level. However, the Federal Reserve, beguiled by its misunderstanding of the real-bills doctrine and its categorical misapplication to central banking, therefore failed abjectly to discharge its responsibility to control the price level. And the Depression came.

On the Price Specie Flow Mechanism

Published January 30, 2021 Bank of France , David Hume , gold standard , Great Depression , Hawtrey , Hayek , Ludwig von Mises , Milton Friedman , price-specie-flow mechanism , sterilization 14 Comments

I have been working on a paper tentatively titled “The Smithian and Humean Traditions in Monetary Theory.” One section of the paper is on the price-specie-flow mechanism, about which I wrote last month in my previous post. This section develops the arguments of the previous post at greater length and draws on a number of earlier posts that I’ve written about PSFM as well (e.g., here and here )provides more detailed criticisms of both PSFM and sterilization and provides some further historical evidence to support some of the theoretical arguments. I will be grateful for any comments and feedback.

The tortured intellectual history of the price-specie-flow mechanism (PSFM) received its still classic exposition in a Hume (1752) essay, which has remained a staple of the theory of international adjustment under the gold standard, or any international system of fixed exchange rates. Regrettably, the two-and-a-half-century life span of PSFM provides no ground for optimism about the prospects for progress in what some are pleased to call without irony economic science.

PSFM describes how, under a gold standard, national price levels tend to be equalized, with deviations between the national price levels in any two countries inducing gold to be shipped from the country with higher prices to the one with lower prices until prices are equalized. Premised on a version of the quantity theory of money in which (1) the price level in each country on the gold standard is determined by the quantity of money in that country, and (2) money consists entirely in gold coin or bullion, Hume elegantly articulated a model of disturbance and equilibration after an exogenous change in the gold stock in one country.

Viewing banks as inflationary engines of financial disorder, Hume disregarded banks and the convertible monetary liabilities of banks in his account of PSFM, leaving to others the task of describing the international adjustment process under a gold standard with fractional-reserve banking. The task of devising an institutional framework, within which PSFM could operate, for a system of fractional-reserve banking proved to be problematic and ultimately unsuccessful.

For three-quarters of a century, PSFM served a purely theoretical function. During the Bullionist debates of the first two decades of the nineteenth century, triggered by the suspension of the convertibility of the pound sterling into gold in 1797, PSFM served as a theoretical benchmark not a guide for policy, it being generally assumed that, when convertibility was resumed, international monetary equilibrium would be restored automatically.

However, the 1821 resumption was followed by severe and recurring monetary disorders, leading some economists, who formed what became known as the Currency School, to view PSFM as a normative criterion for ensuring smooth adjustment to international gold flows. That criterion, the Currency Principle, stated that the total currency in circulation in Britain should increase or decrease by exactly as much as the amount of gold flowing into or out of Britain.[1]

The Currency Principle was codified by the Bank Charter Act of 1844. To mimic the Humean mechanism, it restricted, but did not suppress, the right of note-issuing banks in England and Wales, which were allowed to continue issuing notes, at current, but no higher, levels, without holding equivalent gold reserves. Scottish and Irish note-issuing banks were allowed to continue issuing notes, but could increase their note issue only if matched by increased holdings of gold or government debt. In England and Wales, the note issue could increase only if gold was exchanged for Bank of England notes, so that a 100-percent marginal gold reserve requirement was imposed on additional banknotes.

Opposition to the Bank Charter Act was led by the Banking School, notably John Fullarton and Thomas Tooke. Rejecting the Humean quantity-theoretic underpinnings of the Currency School and the Bank Charter Act, the Banking School rejected the quantitative limits of the Bank Charter Act as both unnecessary and counterproductive, because banks, obligated to redeem their liabilities directly or indirectly in gold, issue liabilities only insofar as they expect those liabilities to be willingly held by the public, or, if not, are capable of redeeming any liabilities no longer willingly held. Rather than the Humean view that banks issue banknotes or create deposits without constraint, the Banking School held Smith’s view that banks issue money in a form more convenient to hold and to transact with than metallic money, so that bank money allows an equivalent amount of gold to be shifted from monetary to real (non-monetary) uses, providing a net social savings. For a small open economy, the diversion (and likely export) of gold bullion from monetary to non-monetary uses has negligible effect on prices (which are internationally, not locally, determined).

The quarter century following enactment of the Bank Charter Act showed that the Act had not eliminated monetary disturbances, the government having been compelled to suspend the Act in 1847, 1857 and 1866 to prevent incipient crises from causing financial collapse. Indeed, it was precisely the fear that liquidity might not be forthcoming that precipitated increased demands for liquidity that the Act made it impossible to accommodate. Suspending the Act was sufficient to end the crises with limited intervention by the Bank. [check articles on the crises of 1847, 1857 and 1866.]

It may seem surprising, but the disappointing results of the Bank Charter Act provided little vindication to the Banking School. It led only to a partial, uneasy, and not entirely coherent, accommodation between PSFM doctrine and the reality of a monetary system in which the money stock consists mostly of banknotes and bank deposits issued by fractional-reserve banks. But despite the failure of the Bank Charter Act, PSFM achieved almost canonical status, continuing, albeit with some notable exceptions, to serve as the textbook model of the gold standard.

The requirement that gold flows induce equal changes in the quantity of money within a country into (or from) which gold is flowing was replaced by an admonition that gold flows lead to “appropriate” changes in the central-bank discount rate or an alternative monetary instrument to cause the quantity of money to change in the same direction as the gold flow. While such vague maxims, sometimes described as “the rules of the game,” gave only directional guidance about how to respond to change in gold reserves, their hortatory character, and avoidance of quantitative guidance, allowed monetary authorities latitude to avoid the self-inflicted crises that had resulted from the quantitative limits of the Bank Charter Act.

Nevertheless, the myth of vague “rules” relating the quantity of money in a country to changes in gold reserves, whose observance ensured the smooth functioning of the international gold standard before its collapse at the start of World War I, enshrined PSFM as the theoretical paradigm for international monetary adjustment under the gold standard.

That paradigm was misconceived in four ways that can be briefly summarized.

  • Contrary to PSFM, changes in the quantity of money in a gold-standard country cannot change local prices proportionately, because prices of tradable goods in that country are constrained by arbitrage to equal the prices of those goods in other countries.
  • Contrary to PSFM, changes in local gold reserves are not necessarily caused either by non-monetary disturbances such as shifts in the terms of trade between countries or by local monetary disturbances (e.g. overissue by local banks) that must be reversed or counteracted by central-bank policy.
  • Contrary to PSFM, changes in the national price levels of gold-standard countries were uncorrelated with gold flows, and changes in national price levels were positively, not negatively, correlated.
  • Local banks and monetary authorities exhibit their own demands for gold reserves, demands exhibited by choice (i.e., independent of legally required gold holdings) or by law (i.e., by legally requirement to hold gold reserves equal to some fraction of banknotes issued by banks or monetary authorities). Such changes in gold reserves may be caused by changes in the local demands for gold by local banks and the monetary authorities in one or more countries.

Many of the misconceptions underlying PSFM were identified by Fullarton’s refutation of the Currency School. In articulating the classical Law of Reflux, he established the logical independence of the quantity convertible money in a country from by the quantity of gold reserves held by the monetary authority. The gold reserves held by individual banks, or their deposits with the Bank of England, are not the raw material from which banks create money, either banknotes or deposits. Rather, it is their creation of banknotes or deposits when extending credit to customers that generates a derived demand to hold liquid assets (i.e., gold) to allow them to accommodate the demands of customers and other banks to redeem banknotes and deposits. Causality runs from creating banknotes and deposits to holding reserves, not vice versa.

The misconceptions inherent in PSFM and the resulting misunderstanding of gold flows under the gold standard led to a further misconception known as sterilization: the idea that central banks, violating the obligations imposed by “the rules of the game,” do not allow, or deliberately prevent, local money stocks from changing as their gold holdings change. The misconception is the presumption that gold inflows ought necessarily cause increases in local money stocks. The mechanisms causing local money stocks to change are entirely different from those causing gold flows. And insofar as those mechanisms are related, causality flows from the local money stock to gold reserves, not vice versa.

Gold flows also result when monetary authorities transform their own asset holdings into gold. Notable examples of such transformations occurred in the 1870s when a number of countries abandoned their de jure bimetallic (and de facto silver) standards to the gold standard. Monetary authorities in those countries transformed silver holdings into gold, driving the value of gold up and silver down. Similarly, but with more catastrophic consequences, the Bank of France, in 1928 after France restored the gold standard, began redeeming holdings of foreign-exchange reserves (financial claims on the United States or Britain, payable in gold) into gold. Following the French example, other countries rejoining the gold standard redeemed foreign exchange for gold, causing gold appreciation and deflation that led to the Great Depression.

Rereading the memoirs of this splendid translation . . . has impressed me with important subtleties that I missed when I read the memoirs in a language not my own and in which I am far from completely fluent. Had I fully appreciated those subtleties when Anna Schwartz and I were writing our A Monetary History of the United States, we would likely have assessed responsibility for the international character of the Great Depression somewhat differently. We attributed responsibility for the initiation of a worldwide contraction to the United States and I would not alter that judgment now. However, we also remarked, “The international effects were severe and the transmission rapid, not only because the gold-exchange standard had rendered the international financial system more vulnerable to disturbances, but also because the United States did not follow gold-standard rules.” Were I writing that sentence today, I would say “because the United States and France did not follow gold-standard rules.”

I pause to note for the record Friedman’s assertion that the United States and France did not follow “gold-standard rules.” Warming up to the idea, he then accused them of sterilization.

Benjamin Strong and Emile Moreau were admirable characters of personal force and integrity. But . . .the common policies they followed were misguided and contributed to the severity and rapidity of transmission of the U.S. shock to the international community. We stressed that the U.S. “did not permit the inflow of gold to expand the U.S. money stock. We not only sterilized it, we went much further. Our money stock moved perversely, going down as the gold stock went up” from 1929 to 1931.

Strong and Moreau tried to reconcile two ultimately incompatible objectives: fixed exchange rates and internal price stability. Thanks to the level at which Britain returned to gold in 1925, the U.S. dollar was undervalued, and thanks to the level at which France returned to gold at the end of 1926, so was the French franc. Both countries as a result experienced substantial gold inflows. Gold-standard rules called for letting the stock of money rise in response to the gold inflows and for price inflation in the U.S. and France, and deflation in Britain, to end the over-and under-valuations. But both Strong and Moreau were determined to prevent inflation and accordingly both sterilized the gold inflows, preventing them from providing the required increase in the quantity of money.

Friedman’s discussion of sterilization is at odds with basic theory. Working with a naïve version of PSFM, he imagines that gold flows passively respond to trade balances independent of monetary forces, and that the monetary authority under a gold standard is supposed to ensure that the domestic money stock varies roughly in proportion to its gold reserves. Ignoring the international deflationary dynamic, he asserts that the US money stock perversely declined from 1929 to 1931, while its gold stock increased. With a faltering banking system, the public shifted from holding demand deposits to currency. Gold reserves were legally required against currency, but not against demand deposits, so the shift from deposits to currency entailed an increase gold reserves. To be sure the increased US demand for gold added to upward pressure on value of gold, and to worldwide deflationary pressure. But US gold holdings rose by only $150 million from December 1929 to December 1931 compared with an increase of $1.06 billion in French gold holdings over the same period. Gold accumulation by the US and its direct contribution to world deflation during the first two years of the Depression was small relative to that of France.

Friedman also erred in stating “the common policies they followed were misguided and contributed to the severity and rapidity of transmission of the U.S. shock to the international community.” The shock to the international community clearly originated not in the US but in France. The Fed could have absorbed and mitigated the shock by allowing a substantial outflow of its huge gold reserves, but instead amplified the shock by raising interest rates to nearly unprecedented levels, causing gold to flow into the US.

After correctly noting the incompatibility between fixed exchange rates and internal price stability, Friedman contradicts himself by asserting that, in seeking to stabilize their internal price levels, Strong and Moreau violated the gold-standard “rules,” as if it were rules, not arbitrage, that constrain national price to converge toward a common level under a gold standard.

Friedman’s assertion that, after 1925, the dollar was undervalued and sterling overvalued was not wrong. But he misunderstood the consequences of currency undervaluation and overvaluation under the gold standard, a confusion stemming from the underlying misconception, derived from PSFM, that foreign exchange rates adjust to balance trade flows, so that, in equilibrium, no country runs a trade deficit or trade surplus.

Thus, in Friedman’s view, dollar undervaluation and sterling overvaluation implied a US trade surplus and British trade deficit, causing gold to flow from Britain to the US. Under gold-standard “rules,” the US money stock and US prices were supposed to rise and the British money stock and British prices were supposed to fall until undervaluation and overvaluation were eliminated. Friedman therefore blamed sterilization of gold inflows by the Fed for preventing the necessary increase in the US money stock and price level to restore equilibrium. But, in fact, from 1925 through 1928, prices in the US were roughly stable and prices in Britain fell slightly. Violating gold-standard “rules” did not prevent the US and British price levels from converging, a convergence driven by market forces, not “rules.”

The stance of monetary policy in a gold-standard country had minimal effect on either the quantity of money or the price level in that country, which were mainly determined by the internationally determined value of gold. What the stance of national monetary policy determines under the gold standard is whether the quantity of money in the country adjusts to the quantity demanded by a process of domestic monetary creation or withdrawal or by the inflow or outflow of gold. Sufficiently tight domestic monetary policy restricting the quantify of domestic money causes a compensatory gold inflow increasing the domestic money stock, while sufficiently easy money causes a compensatory outflow of gold reducing the domestic money stock. Tightness or ease of domestic monetary policy under the gold standard mainly affected gold and foreign-exchange reserves, and, only minimally, the quantity of domestic money and the domestic price level.

However, the combined effects of many countries simultaneously tightening monetary policy in a deliberate, or even inadvertent, attempt to accumulate — or at least prevent the loss — of gold reserves could indeed drive up the international value of gold through a deflationary process affecting prices in all gold-standard countries. Friedman, even while admitting that, in his Monetary History, he had understated the effect of the Bank of France on the Great Depression, referred only the overvaluation of sterling and undervaluation of the dollar and franc as causes of the Great Depression, remaining oblivious to the deflationary effects of gold accumulation and appreciation.

It was thus nonsensical for Friedman to argue that the mistake of the Bank of France during the Great Depression was not to increase the quantity of francs in proportion to the increase of its gold reserves. The problem was not that the quantity of francs was too low; it was that the Bank of France prevented the French public from collectively increasing the quantity of francs that they held except by importing gold.

Unlike Friedman, F. A. Hayek actually defended the policy of the Bank of France, and denied that the Bank of France had violated “the rules of the game” after nearly quadrupling its gold reserves between 1928 and 1932. Under his interpretation of those “rules,” because the Bank of France increased the quantity of banknotes after the 1928 restoration of convertibility by about as much as its gold reserves increased, it had fully complied with the “rules.” Hayek’s defense was incoherent; under its legal obligation to convert gold into francs at the official conversion rate, the Bank of France had no choice but to increase the quantity of francs by as much as its gold reserves increased.

That eminent economists like Hayek and Friedman could defend, or criticize, the conduct of the Bank of France during the Great Depression, because the Bank either did, or did not, follow “the rules of the game” under which the gold standard operated, shows the uselessness and irrelevance of the “rules of the game” as a guide to policy. For that reason alone, the failure of empirical studies to find evidence that “the rules of the game” were followed during the heyday of the gold standard is unsurprising. But the deeper reason for that lack of evidence is that PSFM, whose implementation “the rules of the game” were supposed to guarantee, was based on a misunderstanding of the international-adjustment mechanism under either the gold standard or any fixed-exchange-rates system.

Despite the grip of PSFM over most of the profession, a few economists did show a deeper understanding of the adjustment mechanism. The idea that the price level in terms of gold directly constrained the movements of national price levels across countries was indeed recognized by writers as diverse as Keynes, Mises, and Hawtrey who all pointed out that the prices of internationally traded commodities were constrained by arbitrage and that the free movement of capital across countries would limit discrepancies in interest rates across countries attached to the gold standard, observations that had already been made by Smith, Thornton, Ricardo, Fullarton and Mill in the classical period. But, until the Monetary Approach to the Balance of Payments became popular in the 1970s, only Hawtrey consistently and systematically deduced the implications of those insights in analyzing both the Great Depression and the Bretton Woods system of fixed, but adjustable, exchange rates following World War II.

The inconsistencies and internal contradictions of PSFM were sometimes recognized, but usually overlooked, by business-cycle theorists when focusing on the disturbing influence of central banks, perpetuating mistakes of the Humean Currency School doctrine that attributed cyclical disturbances to the misbehavior of local banking systems that were inherently disposed to overissue their liabilities.

An Austrian Tragedy

Published May 24, 2020 Alfred Marshall , Carl Menger , E. v. Bohm-Bawerk , expectations , general equilibrium , Great Depression , Hayek , Irving Fisher , IS-LM , Israel Kirzner , Joseph Schumpeter , Keynes , Leon Walras , Ludwig Lachmann , Ludwig von Mises , macroeconomics , neoclassical synthesis , New Classical macroeconomics , New Keynesians , Old Keynesians , Oskar Morgensterm , rational expectations , rational expectations equilibrium , representative agent , Walrasian equilibrium 32 Comments
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It was hardly predictable that the New York Review of Books would take notice of Marginal Revolutionaries by Janek Wasserman, marking the susquicentenial of the publication of Carl Menger’s Grundsätze (Principles of Economics) which, along with Jevons’s Principles of Political Economy and Walras’s Elements of Pure Economics ushered in the marginal revolution upon which all of modern economics, for better or for worse, is based. The differences among the three founding fathers of modern economic theory were not insubstantial, and the Jevonian version was largely superseded by the work of his younger contemporary Alfred Marshall, so that modern neoclassical economics is built on the work of only one of the original founders, Leon Walras, Jevons’s work having left little impression on the future course of economics.

Menger’s work, however, though largely, but not totally, eclipsed by that of Marshall and Walras, did leave a more enduring imprint and a more complicated legacy than Jevons’s — not only for economics, but for political theory and philosophy, more generally. Judging from Edward Chancellor’s largely favorable review of Wasserman’s volume, one might even hope that a start might be made in reassessing that legacy, a process that could provide an opportunity for mutually beneficial interaction between long-estranged schools of thought — one dominant and one marginal — that are struggling to overcome various conceptual, analytical and philosophical problems for which no obvious solutions seem available.

In view of the failure of modern economists to anticipate the Great Recession of 2008, the worst financial shock since the 1930s, it was perhaps inevitable that the Austrian School, a once favored branch of economics that had made a specialty of booms and busts, would enjoy a revival of public interest.

The theme of Austrians as outsiders runs through Janek Wasserman’s The Marginal Revolutionaries: How Austrian Economists Fought the War of Ideas, a general history of the Austrian School from its beginnings to the present day. The title refers both to the later marginalization of the Austrian economists and to the original insight of its founding father, Carl Menger, who introduced the notion of marginal utility—namely, that economic value does not derive from the cost of inputs such as raw material or labor, as David Ricardo and later Karl Marx suggested, but from the utility an individual derives from consuming an additional amount of any good or service. Water, for instance, may be indispensable to humans, but when it is abundant, the marginal value of an extra glass of the stuff is close to zero. Diamonds are less useful than water, but a great deal rarer, and hence command a high market price. If diamonds were as common as dewdrops, however, they would be worthless.

Menger was not the first economist to ponder . . . the “paradox of value” (why useless things are worth more than essentials)—the Italian Ferdinando Galiani had gotten there more than a century earlier. His central idea of marginal utility was simultaneously developed in England by W. S. Jevons and on the Continent by Léon Walras. Menger’s originality lay in applying his theory to the entire production process, showing how the value of capital goods like factory equipment derived from the marginal value of the goods they produced. As a result, Austrian economics developed a keen interest in the allocation of capital. Furthermore, Menger and his disciples emphasized that value was inherently subjective, since it depends on what consumers are willing to pay for something; this imbued the Austrian school from the outset with a fiercely individualistic and anti-statist aspect.

Menger’s unique contribution is indeed worthy of special emphasis. He was more explicit than Jevons or Walras, and certainly more than Marshall, in explaining that the value of factors of production is derived entirely from the value of the incremental output that could be attributed (or imputed) to their services. This insight implies that cost is not an independent determinant of value, as Marshall, despite accepting the principle of marginal utility, continued to insist – famously referring to demand and supply as the two blades of the analytical scissors that determine value. The cost of production therefore turns out to be nothing but the value the output foregone when factors are used to produce one output instead of the next most highly valued alternative. Cost therefore does not determine, but is determined by, equilibrium price, which means that, in practice, costs are always subjective and conjectural. (I have made this point in an earlier post in a different context.) I will have more to say below about the importance of Menger’s specific contribution and its lasting imprint on the Austrian school.

Menger’s Principles of Economics, published in 1871, established the study of economics in Vienna—before then, no economic journals were published in Austria, and courses in economics were taught in law schools. . . .

The Austrian School was also bound together through family and social ties: [his two leading disciples, [Eugen von] Böhm-Bawerk and Friedrich von Wieser [were brothers-in-law]. [Wieser was] a close friend of the statistician Franz von Juraschek, Friedrich Hayek’s maternal grandfather. Young Austrian economists bonded on Alpine excursions and met in Böhm-Bawerk’s famous seminars (also attended by the Bolshevik Nikolai Bukharin and the German Marxist Rudolf Hilferding). Ludwig von Mises continued this tradition, holding private seminars in Vienna in the 1920s and later in New York. As Wasserman notes, the Austrian School was “a social network first and last.”

After World War I, the Habsburg Empire was dismantled by the victorious Allies. The Austrian bureaucracy shrank, and university placements became scarce. Menger, the last surviving member of the first generation of Austrian economists, died in 1921. The economic school he founded, with its emphasis on individualism and free markets, might have disappeared under the socialism of “Red Vienna.” Instead, a new generation of brilliant young economists emerged: Schumpeter, Hayek, and Mises—all of whom published best-selling works in English and remain familiar names today—along with a number of less well known but influential economists, including Oskar Morgenstern, Fritz Machlup, Alexander Gerschenkron, and Gottfried Haberler.

Two factual corrections are in order. Menger outlived Böhm-Bawerk, but not his other chief disciple von Wieser, who died in 1926, not long after supervising Hayek’s doctoral dissertation, later published in 1927, and, in 1933, translated into English and published as Monetary Theory and the Trade Cycle. Moreover, a 16-year gap separated Mises and Schumpeter, who were exact contemporaries, from Hayek (born in 1899) who was a few years older than Gerschenkron, Haberler, Machlup and Morgenstern.

All the surviving members or associates of the Austrian school wound up either in the US or Britain after World War II, and Hayek, who had taken a position in London in 1931, moved to the US in 1950, taking a position in the Committee on Social Thought at the University of Chicago after having been refused a position in the economics department. Through the intervention of wealthy sponsors, Mises obtained an academic appointment of sorts at the NYU economics department, where he succeeded in training two noteworthy disciples who wrote dissertations under his tutelage, Murray Rothbard and Israel Kirzner. (Kirzner wrote his dissertation under Mises at NYU, but Rothbard did his graduate work at Colulmbia.) Schumpeter, Haberler and Gerschenkron eventually took positions at Harvard, while Machlup (with some stops along the way) and Morgenstern made their way to Princeton. However, Hayek’s interests shifted from pure economic theory to deep philosophical questions. While Machlup and Haberler continued to work on economic theory, the Austrian influence on their work after World War II was barely recognizable. Morgenstern and Schumpeter made major contributions to economics, but did not hide their alienation from the doctrines of the Austrian School.

So there was little reason to expect that the Austrian School would survive its dispersal when the Nazis marched unopposed into Vienna in 1938. That it did survive is in no small measure due to its ideological usefulness to anti-socialist supporters who provided financial support to Hayek, enabling his appointment to the Committee on Social Thought at the University of Chicago, and Mises’s appointment at NYU, and other forms of research support to Hayek, Mises and other like-minded scholars, as well as funding the Mont Pelerin Society, an early venture in globalist networking, started by Hayek in 1947. Such support does not discredit the research to which it gave rise. That the survival of the Austrian School would probably not have been possible without the support of wealthy benefactors who anticipated that the Austrians would advance their political and economic interests does not invalidate the research thereby enabled. (In the interest of transparency, I acknowledge that I received support from such sources for two books that I wrote.)

Because Austrian School survivors other than Mises and Hayek either adapted themselves to mainstream thinking without renouncing their earlier beliefs (Haberler and Machlup) or took an entirely different direction (Morgenstern), and because the economic mainstream shifted in two directions that were most uncongenial to the Austrians: Walrasian general-equilibrium theory and Keynesian macroeconomics, the Austrian remnant, initially centered on Mises at NYU, adopted a sharply adversarial attitude toward mainstream economic doctrines.

Despite its minute numbers, the lonely remnant became a house divided against itself, Mises’s two outstanding NYU disciples, Murray Rothbard and Israel Kirzner, holding radically different conceptions of how to carry on the Austrian tradition. An extroverted radical activist, Rothbard was not content just to lead a school of economic thought, he aspired to become the leader of a fantastical anarchistic revolutionary movement to replace all established governments under a reign of private-enterprise anarcho-capitalism. Rothbard’s political radicalism, which, despite his Jewish ancestry, even included dabbling in Holocaust denialism, so alienated his mentor, that Mises terminated all contact with Rothbard for many years before his death. Kirzner, self-effacing, personally conservative, with no political or personal agenda other than the advancement of his own and his students’ scholarship, published hundreds of articles and several books filling 10 thick volumes of his collected works published by the Liberty Fund, while establishing a robust Austrian program at NYU, training many excellent scholars who found positions in respected academic and research institutions. Similar Austrian programs, established under the guidance of Kirzner’s students, were started at other institutions, most notably at George Mason University.

One of the founders of the Cato Institute, which for nearly half a century has been the leading avowedly libertarian think tank in the US, Rothbard was eventually ousted by Cato, and proceeded to set up a rival think tank, the Ludwig von Mises Institute, at Auburn University, which has turned into a focal point for extreme libertarians and white nationalists to congregate, get acquainted, and strategize together.

Isolation and marginalization tend to cause a subspecies either to degenerate toward extinction, to somehow blend in with the members of the larger species, thereby losing its distinctive characteristics, or to accentuate its unique traits, enabling it to find some niche within which to survive as a distinct sub-species. Insofar as they have engaged in economic analysis rather than in various forms of political agitation and propaganda, the Rothbardian Austrians have focused on anarcho-capitalist theory and the uniquely perverse evils of fractional-reserve banking.

Rejecting the political extremism of the Rothbardians, Kirznerian Austrians differentiate themselves by analyzing what they call market processes and emphasizing the limitations on the knowledge and information possessed by actual decision-makers. They attribute this misplaced focus on equilibrium to the extravagantly unrealistic and patently false assumptions of mainstream models on the knowledge possessed by economic agents, which effectively make equilibrium the inevitable — and trivial — conclusion entailed by those extreme assumptions. In their view, the focus of mainstream models on equilibrium states with unrealistic assumptions results from a preoccupation with mathematical formalism in which mathematical tractability rather than sound economics dictates the choice of modeling assumptions.

Skepticism of the extreme assumptions about the informational endowments of agents covers a range of now routine assumptions in mainstream models, e.g., the ability of agents to form precise mathematical estimates of the probability distributions of future states of the world, implying that agents never confront decisions about which they are genuinely uncertain. Austrians also object to the routine assumption that all the information needed to determine the solution of a model is the common knowledge of the agents in the model, so that an existing equilibrium cannot be disrupted unless new information randomly and unpredictably arrives. Each agent in the model having been endowed with the capacity of a semi-omniscient central planner, solving the model for its equilibrium state becomes a trivial exercise in which the optimal choices of a single agent are taken as representative of the choices made by all of the model’s other, semi-omnicient, agents.

Although shreds of subjectivism — i.e., agents make choices based own preference orderings — are shared by all neoclassical economists, Austrian criticisms of mainstream neoclassical models are aimed at what Austrians consider to be their insufficient subjectivism. It is this fierce commitment to a robust conception of subjectivism, in which an equilibrium state of shared expectations by economic agents must be explained, not just assumed, that Chancellor properly identifies as a distinguishing feature of the Austrian School.

Menger’s original idea of marginal utility was posited on the subjective preferences of consumers. This subjectivist position was retained by subsequent generations of the school. It inspired a tradition of radical individualism, which in time made the Austrians the favorite economists of American libertarians. Subjectivism was at the heart of the Austrians’ polemical rejection of Marxism. Not only did they dismiss Marx’s labor theory of value, they argued that socialism couldn’t possibly work since it would lack the means to allocate resources efficiently.

The problem with central planning, according to Hayek, is that so much of the knowledge that people act upon is specific knowledge that individuals acquire in the course of their daily activities and life experience, knowledge that is often difficult to articulate – mere intuition and guesswork, yet more reliable than not when acted upon by people whose livelihoods depend on being able to do the right thing at the right time – much less communicate to a central planner.

Chancellor attributes Austrian mistrust of statistical aggregates or indices, like GDP and price levels, to Austrian subjectivism, which regards such magnitudes as abstractions irrelevant to the decisions of private decision-makers, except perhaps in forming expectations about the actions of government policy makers. (Of course, this exception potentially provides full subjectivist license and legitimacy for macroeconomic theorizing despite Austrian misgivings.) Observed statistical correlations between aggregate variables identified by macroeconomists are dismissed as irrelevant unless grounded in, and implied by, the purposeful choices of economic agents.

But such scruples about the use of macroeconomic aggregates and inferring causal relationships from observed correlations are hardly unique to the Austrian school. One of the most important contributions of the 20th century to the methodology of economics was an article by T. C. Koopmans, “Measurement Without Theory,” which argued that measured correlations between macroeconomic variables provide a reliable basis for business-cycle research and policy advice only if the correlations can be explained in terms of deeper theoretical or structural relationships. The Nobel Prize Committee, in awarding the 1975 Prize to Koopmans, specifically mentioned this paper in describing Koopmans’s contributions. Austrians may be more fastidious than their mainstream counterparts in rejecting macroeconomic relationships not based on microeconomic principles, but they aren’t the only ones mistrustful of mere correlations.

Chancellor cites mistrust about the use of statistical aggregates and price indices as a factor in Hayek’s disastrous policy advice warning against anti-deflationary or reflationary measures during the Great Depression.

Their distrust of price indexes brought Austrian economists into conflict with mainstream economic opinion during the 1920s. At the time, there was a general consensus among leading economists, ranging from Irving Fisher at Yale to Keynes at Cambridge, that monetary policy should aim at delivering a stable price level, and in particular seek to prevent any decline in prices (deflation). Hayek, who earlier in the decade had spent time at New York University studying monetary policy and in 1927 became the first director of the Austrian Institute for Business Cycle Research, argued that the policy of price stabilization was misguided. It was only natural, Hayek wrote, that improvements in productivity should lead to lower prices and that any resistance to this movement (sometimes described as “good deflation”) would have damaging economic consequences.

The argument that deflation stemming from economic expansion and increasing productivity is normal and desirable isn’t what led Hayek and the Austrians astray in the Great Depression; it was their failure to realize the deflation that triggered the Great Depression was a monetary phenomenon caused by a malfunctioning international gold standard. Moreover, Hayek’s own business-cycle theory explicitly stated that a neutral (stable) monetary policy ought to aim at keeping the flow of total spending and income constant in nominal terms while his policy advice of welcoming deflation meant a rapidly falling rate of total spending. Hayek’s policy advice was an inexcusable error of judgment, which, to his credit, he did acknowledge after the fact, though many, perhaps most, Austrians have refused to follow him even that far.

Considered from the vantage point of almost a century, the collapse of the Austrian School seems to have been inevitable. Hayek’s long-shot bid to establish his business-cycle theory as the dominant explanation of the Great Depression was doomed from the start by the inadequacies of the very specific version of his basic model and his disregard of the obvious implication of that model: prevent total spending from contracting. The promising young students and colleagues who had briefly gathered round him upon his arrival in England, mostly attached themselves to other mentors, leaving Hayek with only one or two immediate disciples to carry on his research program. The collapse of his research program, which he himself abandoned after completing his final work in economic theory, marked a research hiatus of almost a quarter century, with the notable exception of publications by his student, Ludwig Lachmann who, having decamped in far-away South Africa, labored in relative obscurity for most of his career.

The early clash between Keynes and Hayek, so important in the eyes of Chancellor and others, is actually overrated. Chancellor, quoting Lachmann and Nicholas Wapshott, describes it as a clash of two irreconcilable views of the economic world, and the clash that defined modern economics. In later years, Lachmann actually sought to effect a kind of reconciliation between their views. It was not a conflict of visions that undid Hayek in 1931-32, it was his misapplication of a narrowly constructed model to a problem for which it was irrelevant.

Although the marginalization of the Austrian School, after its misguided policy advice in the Great Depression and its dispersal during and after World War II, is hardly surprising, the unwillingness of mainstream economists to sort out what was useful and relevant in the teachings of the Austrian School from what is not was unfortunate not only for the Austrians. Modern economics was itself impoverished by its disregard for the complexity and interconnectedness of economic phenomena. It’s precisely the Austrian attentiveness to the complexity of economic activity — the necessity for complementary goods and factors of production to be deployed over time to satisfy individual wants – that is missing from standard economic models.

That Austrian attentiveness, pioneered by Menger himself, to the complementarity of inputs applied over the course of time undoubtedly informed Hayek’s seminal contribution to economic thought: his articulation of the idea of intertemporal equilibrium that comprehends the interdependence of the plans of independent agents and the need for them to all fit together over the course of time for equilibrium to obtain. Hayek’s articulation represented a conceptual advance over earlier versions of equilibrium analysis stemming from Walras and Pareto, and even from Irving Fisher who did pay explicit attention to intertemporal equilibrium. But in Fisher’s articulation, intertemporal consistency was described in terms of aggregate production and income, leaving unexplained the mechanisms whereby the individual plans to produce and consume particular goods over time are reconciled. Hayek’s granular exposition enabled him to attend to, and articulate, necessary but previously unspecified relationships between the current prices and expected future prices.

Moreover, neither mainstream nor Austrian economists have ever explained how prices are adjust in non-equilibrium settings. The focus of mainstream analysis has always been the determination of equilibrium prices, with the implicit understanding that “market forces” move the price toward its equilibrium value. The explanatory gap has been filled by the mainstream New Classical School which simply posits the existence of an equilibrium price vector, and, to replace an empirically untenable tâtonnement process for determining prices, posits an equally untenable rational-expectations postulate to assert that market economies typically perform as if they are in, or near the neighborhood of, equilibrium, so that apparent fluctuations in real output are viewed as optimal adjustments to unexplained random productivity shocks.

Alternatively, in New Keynesian mainstream versions, constraints on price changes prevent immediate adjustments to rationally expected equilibrium prices, leading instead to persistent reductions in output and employment following demand or supply shocks. (I note parenthetically that the assumption of rational expectations is not, as often suggested, an assumption distinct from market-clearing, because the rational expectation of all agents of a market-clearing price vector necessarily implies that the markets clear unless one posits a constraint, e.g., a binding price floor or ceiling, that prevents all mutually beneficial trades from being executed.)

Similarly, the Austrian school offers no explanation of how unconstrained price adjustments by market participants is a sufficient basis for a systemic tendency toward equilibrium. Without such an explanation, their belief that market economies have strong self-correcting properties is unfounded, because, as Hayek demonstrated in his 1937 paper, “Economics and Knowledge,” price adjustments in current markets don’t, by themselves, ensure a systemic tendency toward equilibrium values that coordinate the plans of independent economic agents unless agents’ expectations of future prices are sufficiently coincident. To take only one passage of many discussing the difficulty of explaining or accounting for a process that leads individuals toward a state of equilibrium, I offer the following as an example:

All that this condition amounts to, then, is that there must be some discernible regularity in the world which makes it possible to predict events correctly. But, while this is clearly not sufficient to prove that people will learn to foresee events correctly, the same is true to a hardly less degree even about constancy of data in an absolute sense. For any one individual, constancy of the data does in no way mean constancy of all the facts independent of himself, since, of course, only the tastes and not the actions of the other people can in this sense be assumed to be constant. As all those other people will change their decisions as they gain experience about the external facts and about other people’s actions, there is no reason why these processes of successive changes should ever come to an end. These difficulties are well known, and I mention them here only to remind you how little we actually know about the conditions under which an equilibrium will ever be reached.

In this theoretical muddle, Keynesian economics and the neoclassical synthesis were abandoned, because the key proposition of Keynesian economics was supposedly the tendency of a modern economy toward an equilibrium with involuntary unemployment while the neoclassical synthesis rejected that proposition, so that the supposed synthesis was no more than an agreement to disagree. That divided house could not stand. The inability of Keynesian economists such as Hicks, Modigliani, Samuelson and Patinkin to find a satisfactory (at least in terms of a preferred Walrasian general-equilibrium model) rationalization for Keynes’s conclusion that an economy would likely become stuck in an equilibrium with involuntary unemployment led to the breakdown of the neoclassical synthesis and the displacement of Keynesianism as the dominant macroeconomic paradigm.

But perhaps the way out of the muddle is to abandon the idea that a systemic tendency toward equilibrium is a property of an economic system, and, instead, to recognize that equilibrium is, as Hayek suggested, a contingent, not a necessary, property of a complex economy. Ludwig Lachmann, cited by Chancellor for his remark that the early theoretical clash between Hayek and Keynes was a conflict of visions, eventually realized that in an important sense both Hayek and Keynes shared a similar subjectivist conception of the crucial role of individual expectations of the future in explaining the stability or instability of market economies. And despite the efforts of New Classical economists to establish rational expectations as an axiomatic equilibrating property of market economies, that notion rests on nothing more than arbitrary methodological fiat.

Chancellor concludes by suggesting that Wasserman’s characterization of the Austrians as marginalized is not entirely accurate inasmuch as “the Austrians’ view of the economy as a complex, evolving system continues to inspire new research.” Indeed, if economics is ever to find a way out of its current state of confusion, following Lachmann in his quest for a synthesis of sorts between Keynes and Hayek might just be a good place to start from.

Hayek’s Rapid Rise to Stardom

Published December 12, 2017 Austrian Business-Cycle Theory , David Laidler , gold standard , Hayek , Larry White , Ludwig von Mises , neutral money 11 Comments
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For a month or so, I have been working on a paper about Hayek’s early pro-deflationary policy recommendations which seem to be at odds with his own idea of neutral money which he articulated in a way that implied or at least suggested that the ideal monetary policy would aim to keep nominal spending or nominal income constant. In the Great Depression, prices and real output were both falling, so that nominal spending and income were also falling at a rate equal to the rate of decline in real output plus the rate of decline in the price level. So in a depression, the monetary policy implied by Hayek’s neutral money criterion would have been to print money like crazy to generate enough inflation to keep nominal spending and nominal income constant. But Hayek denounced any monetary policy that aimed to raise prices during the depression, arguing that such a policy would treat the disease of depression with the drug that had caused the disease in the first place. Decades later, Hayek acknowledged his mistake and made clear that he favored a policy that would prevent the flow of nominal spending from ever shrinking. In this post, I am excerpting the introductory section of the current draft of my paper.

Few economists, if any, ever experienced as rapid a rise to stardom as F. A. Hayek did upon arriving in London in January 1931, at the invitation of Lionel Robbins, to deliver a series of four lectures on the theory of industrial fluctuations. The Great Depression having started about 15 months earlier, British economists were desperately seeking new insights into the unfolding and deteriorating economic catastrophe. The subject on which Hayek was to expound was of more than academic interest; it was of the most urgent economic, political and social, import.

Only 31 years old, Hayek, director of the Austrian Institute of Business Cycle Research headed by his mentor Ludwig von Mises, had never held an academic position. Upon completing his doctorate at the University of Vienna, writing his doctoral thesis under Friedrich von Wieser, one of the eminent figures of the Austrian School of Economics, Hayek, through financial assistance secured by Mises, spent over a year in the United States doing research on business cycles, and meeting such leading American experts on business cycles as W. C. Mitchell. While in the US, Hayek also exhaustively studied the English-language  literature on the monetary history of the eighteenth and nineteenth centuries and the, mostly British, monetary doctrines of that era.

Even without an academic position, Hayek’s productivity upon returning to Vienna was impressive. Aside from writing a monthly digest of statistical reports, financial news, and analysis of business conditions for the Institute, Hayek published several important theoretical papers, gaining a reputation as a young economist of considerable promise. Moreover, Hayek’s immersion in the English monetary literature and his sojourn in the United States gave him an excellent command of English, so that when Robbins, newly installed as head of the economics department at LSE, and having fallen under the influence of the Austrian school of economics, was seeking to replace Edwin Cannan, who before his retirement had been the leading monetary economist at LSE, Robbins thought of Hayek as a candidate for Cannan’s position.

Hoping that Hayek’s performance would be sufficiently impressive to justify the offer of a position at LSE, Robbins undoubtedly made clear to Hayek that if his lectures were well received, his chances of receiving an offer to replace Cannan were quite good. A secure academic position for a young economist, even one as talented as Hayek, was then hard to come by in Austria or Germany. Realizing how much depended on the impression he would make, Hayek, despite having undertaken to write a textbook on monetary theory for which he had already written several chapters, dropped everything else to compose the four lectures that he would present at LSE.

When he arrived in England in January 1931, Hayek actually went first to Cambridge to give a lecture, a condensed version of the four LSE lectures. Hayek was not feeling well when he came to Cambridge to face an unsympathetic, if not hostile, audience, and the lecture was not a success. However, either despite, or because of, his inauspicious debut at Cambridge, Hayek’s performance at LSE turned out to be an immediate sensation. In his History of Economic Analysis, Joseph Schumpeter, who, although an Austrian with a background in economics similar to Hayek’s, was neither a personal friend nor an ideological ally of Hayek’s, wrote that Hayek’s theory

on being presented to the Anglo-American community of economists, met with a sweeping success that has never been equaled by any strictly theoretical book that failed to make amends for its rigors by including plans and policy recommendations or to make contact in other ways with its readers loves or hates. A strong critical reaction followed that, at first, but served to underline the success, and then the profession turned away to other leaders and interests.

The four lectures provided a masterful survey of business-cycle theory and the role of monetary analysis in business-cycle theory, including a lucid summary of the Austrian capital-theoretic approach to business-cycle theory and of the equilibrium price relationships that are conducive to economic stability, an explanation of how those equilibrium price relationships are disturbed by monetary disturbances giving rise to cyclical effects, and some comments on the appropriate policies for avoiding or minimizing such disturbances. The goal of monetary policy should be to set the money interest rate equal to the hypothetical equilibrium interest rate determined by strictly real factors. The only policy implication that Hayek could extract from this rarified analysis was that monetary policy should aim not to stabilize the price level as recommended by such distinguished monetary theorists as Alfred Marshall and Knut Wicksell, but to stabilize total spending or total money income.

This objective would be achieved, Hayek argued, only if injections of new money preserved the equilibrium relationship between savings and investment, investments being financed entirely by voluntary savings, not by money newly created for that purpose. Insofar as new investment projects were financed by newly created money, the additional expenditure thereby financed would entail a deviation from the real equilibrium that would obtain in a hypothetical barter economy or in an economy in which money had no distortionary effect. That  interest rate was called by Hayek, following Wicksell, the natural (or equilibrium) rate of interest.

But according to Hayek, Wicksell failed to see that, in a progressive economy with real investment financed by voluntary saving, the increasing output of goods and services over time implies generally falling prices as the increasing productivity of factors of production progressively reduces costs of production. A stable price level would require ongoing increases in the quantity of money to, the new money being used to finance additional investment over and above voluntary saving, thereby causing the economy to deviate from its equilibrium time path by inducing investment that would not otherwise have been undertaken.

As Paul Zimmerman and I have pointed out in our paper on Hayek’s response to Piero Sraffa’s devastating, but flawed, review of Prices and Production (the published version of Hayek’s LSE lectures) Hayek’s argument that only an economy in which no money is created to finance investment is consistent with the real equilibrium of a pure barter economy depends on the assumption that money is non-interest-bearing and that the rate of inflation is not correctly foreseen. If money bears competitive interest and inflation is correctly foreseen, the economy can attain its real equilibrium regardless of the rate of inflation – provided, at least, that the rate of deflation is not greater than the real rate of interest. Inasmuch as the real equilibrium is defined by a system of n-1 relative prices per time period which can be multiplied by any scalar representing the expected price level or expected rate of inflation between time periods.

So Hayek’s assumption that the real equilibrium requires a rate of deflation equal to the rate of increase in factor productivity is an arbitrary and unfounded assumption reflecting his failure to see that the real equilibrium of the economy is independent of the price levels in different time periods and rates of inflation between time periods, when prices levels and rates of inflation are correctly anticipated. If inflation is correctly foreseen, nominal wages will rise commensurately with inflation and real wages with productivity increases, so that the increase in nominal money supplied by banks will not induce or finance investment beyond voluntary savings. Hayek’s argument was based on a failure to work through the full implications of his equilibrium method. As Hayek would later come to recognize, disequilibrium is the result not of money creation by banks but of mistaken expectations about the future.

Thus, Hayek’s argument mistakenly identified monetary expansion of any sort that moderated or reversed what Hayek considered the natural tendency of prices to fall in a progressively expanding economy, as the disturbing and distorting impulse responsible for business-cycle fluctuations. Although he did not offer a detailed account of the origins of the Great Depression, Hayek’s diagnosis of the causes of the Great Depression, made explicit in various other writings, was clear: monetary expansion by the Federal Reserve during the 1920s — especially in 1927 — to keep the US price level from falling and to moderate deflationary pressure on Britain (sterling having been overvalued at the prewar dollar-sterling parity when Britain restored gold convertibility in March 1925) distorted relative prices and the capital structure. When distortions eventually become unsustainable, unprofitable investment projects would be liquidated, supposedly freeing those resources to be re-employed in more productive activities. Why the Depression continued to deepen rather than recover more than a year after the downturn had started, was another question.

Despite warning of the dangers of a policy of price-level stabilization, Hayek was reluctant to advance an alternative policy goal or criterion beyond the general maxim that policy should avoid any disturbing or distorting effect — in particular monetary expansion — on the economic system. But Hayek was incapable of, or unwilling to, translate this abstract precept into a definite policy norm.

The simplest implementation of Hayek’s objective would be to hold the quantity of money constant. But that policy, as Hayek acknowledged, was beset with both practical and conceptual difficulties. Under a gold standard, which Hayek, at least in the early 1930s, still favored, the relevant area within which to keep the quantity of money constant would be the entire world (or, more precisely, the set of countries linked to the gold standard). But national differences between the currencies on the gold standard would make it virtually impossible to coordinate those national currencies to keep some aggregate measure of the quantity of money convertible into gold constant. And Hayek also recognized that fluctuations in the demand to hold money (the reciprocal of the velocity of circulation) produce monetary disturbances analogous to variations in the quantity of money, so that the relevant policy objective was not to hold the quantity of money constant, but to change the quantity of money proportionately (inversely) with the demand to hold money (the velocity of circulation).

Hayek therefore suggested that the appropriate criterion for the neutrality of money might be to hold total spending (or alternatively total factor income) constant. With constant total spending, neither an increase nor a decrease in the amount of money the public desired to hold would lead to disequilibrium. This was a compelling argument for constant total spending as the goal of policy, but Hayek was unwilling to adopt it as a practical guide for monetary policy.

In the final paragraph of his final LSE lecture, Hayek made his most explicit, though still equivocal, policy recommendation:

[T]he only practical maxim for monetary policy to be derived from our considerations is probably . . . that the simple fact of an increase of production and trade forms no justification for an expansion of credit, and that—save in an acute crisis—bankers need not be afraid to harm production by overcaution. . . . It is probably an illusion to suppose that we shall ever be able entirely to eliminate industrial fluctuations by means of monetary policy. The most we may hope for is that the growing information of the public may make it easier for central banks both to follow a cautious policy during the upward swing of the cycle, and so to mitigate the following depression, and to resist the well-meaning but dangerous proposals to fight depression by “a little inflation “.

Thus, Hayek concluded his series of lectures by implicitly rejecting his own idea of neutral money as a policy criterion, warning instead against the “well-meaning but dangerous proposals to fight depression by ‘a little inflation.’” The only sensible interpretation of Hayek’s counsel of “resistance” is an icy expression of indifference to falling nominal spending in a deep depression.

Larry White has defended Hayek against the charge that his policy advice in the depression was liquidationist, encouraging policy makers to take a “hands-off” approach to the unfolding economic catastrophe. In making this argument, White relies on Hayek’s neutral-money concept as well as Hayek’s disavowals decades later of his early pro-deflation policy advice. However, White omitted any mention of Hayek’s explicit rejection of neutral money as a policy norm at the conclusion of his LSE lectures. White also disputes that Hayek was a liquidationist, arguing that Hayek supported liquidation not for its own sake but only as a means to reallocate resources from lower- to higher-valued uses. Although that is certainly true, White does not establish that any of the other liquidationists he mentions favored liquidation as an end and not, like Hayek, as a means.

Hayek’s policy stance in the early 1930s was characterized by David Laidler as a skepticism bordering on nihilism in opposing any monetary- or fiscal-policy responses to mitigate the suffering of the general public caused by the Depression. White’s efforts at rehabilitation notwithstanding, Laidler’s characterization seems to be on the mark. The perplexing and disturbing question raised by Hayek’s policy stance in the early 1930s is why, given the availability of his neutral-money criterion as a justification for favoring at least a mildly inflationary (or reflationary) policy to promote economic recovery from the Depression, did Hayek remain, during the 1930s at any rate, implacably opposed to expansionary monetary policies? Hayek’s later disavowals of his early position actually provide some insight into his reasoning in the early 1930s, but to understand the reasons for his advocacy of a policy inconsistent with his own theoretical understanding of the situation for which he was offering policy advice, it is necessary to understand the intellectual and doctrinal background that set the boundaries on what kinds of policies Hayek was prepared to entertain. The source of that intellectual and doctrinal background was David Hume and the intermediary through which it was transmitted was none other than Hayek’s mentor Ludwig von Mises.

The Pot Calls the Kettle Black

Published July 17, 2015 Federal Reserve , inflation , Ludwig von Mises , Money Illusion , Say's Law , Uncategorized 7 Comments
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I had not planned to post anything today, but after coming across an article (“What the Fed Really Wants Is to Reduce Real Wages”) by Alex Pollock of AEI on Real Clear Markets this morning, I decided that I could not pass up this opportunity to expose a) a basic, but common and well-entrenched, error in macroeconomic reasoning, and b) the disturbingly hypocritical and deceptive argument in the service of which the faulty reasoning was deployed.

I start by quoting from Pollock’s article.

To achieve economic growth over time, prices have to change in order to adjust resource allocation to changing circumstances. This includes the price of work, or wages. Everybody does or should know this, and the Federal Reserve definitely knows it.

The classic argument for why central banks should create inflation as needed is that this causes real wages to fall, thus allowing the necessary downward adjustment, even while nominal wages don’t fall. Specifically, the argument goes like this: For employment and growth, wages sometimes have to adjust downward; people and politicians don’t like to have nominal wages fall– they are “sticky.” People are subject to Money Illusion and they don’t think in inflation-adjusted terms. Therefore create inflation to make real wages fall.

In an instructive meeting of the Federal Reserve Open Market Committee in July, 1996, the transcript of which has been released, the Fed took up the issue of “long-term inflation goals.” Promoting the cause of what ultimately became the Fed’s goal of 2% inflation forever, then-Fed Governor Janet Yellen made exactly the classic argument. “To my mind,” she said, “the most important argument for some low inflation rate is…that a little inflation lowers unemployment by facilitating adjustments in relative pay”-in other words, by lowering real wages. This reflects “a world where individuals deeply dislike nominal pay cuts,” she continued. “I think we are dealing here with a very deep-rooted property of the human psyche”-that is, Money Illusion.

In sum, since “workers resist and firms are unwilling to impose nominal pay cuts,” the Fed has to be able to reduce real wages instead by inflation.

But somehow the Fed never mentions that this is what it does. It apparently considers it a secret too deep for voters and members of Congress to understand. Perhaps it would be bad PR?

This summary of why some low rate of inflation may promote labor-0market flexibility is not far from the truth, but it does require some disambiguation. The first distinction to make is that while Janet Yellen was talking about adjustments in relative pay, presumably adjustments in wages both across different occupations and also across different geographic areas — a necessity even if the overall level of real wages is stable — Pollock simply talks about reducing real wages in general.

But there is a second, more subtle distinction to make here as well, and that distinction makes a big difference in how we understand what the Fed is trying to do. Suppose a reduction in real wages in general, or in the relative wages of some workers is necessary for labor-market equilibrium. To suggest that only reason to use inflation to reduce the need for nominal wage cuts is a belief in “Money Illusion” is deeply misleading. The concept of “Money Illusion” is only meaningful when applied to equilibrium states of the economy. Thus the absence of “Money Illusion” means that the equilibrium of the economy (under the assumption that the economy has a unique equilibrium — itself, a very questionable assumption, but let’s not get diverted from this discussion to an even messier and more complicated one) is the same regardless of how nominal prices are scaled up or down. It is entirely possible to accept that proposition (which seems to follow from fairly basic rationality assumptions) without also accepting that it is irrelevant whether real-wage reductions in response to changing circumstances are brought about by inflation or by nominal-wage cuts.

Since any discussion of changes in relative wages presumes that a transition from one equilibrium state to another equilibrium state is occurring, the absence of Money Illusion, being a property of equilibrium,  can’t tell us anything about whether the transition from one equilibrium state to another is more easily accomplished by way of nominal-wage cuts or by way of inflation. If, as a wide range of historical evidence suggests, real-wage reductions are more easily effected by way of inflation than by way of nominal-wage cuts, it is plausible to assume that minimizing nominal-wage cuts will ease the transition from the previous equilibrium to the new one.

Why is that? Here’s one way to think about it. The resistance to nominal-wage cuts implies that more workers will be unemployed initially if nominal wages are cut than if there is an inflationary strategy. It’s true that the unemployment is transitory (in some sense), but the transitory unemployment will be with reduced demand for other products, so the effect of unemployment of some workers is felt by other sectors adn other workers. This implication is not simply the multiplier effect of Keynesian economics, it is also a direct implication of the widely misunderstood Say’s Law, which says that supply creates its own demand. So if workers are more likely to become unemployed in the transition to an equilibrium with reduced real wages if the real-wage reduction is accomplished via a cut in nominal wages than if accomplished by inflation, then inflation reduces the reduction in demand associated with resistance to nominal-wage cuts. The point is simply that we have to consider not just the final destination, but also the route by which we get there. Sometimes the route to a destination may be so difficult and so dangerous, that we are better off not taking it and looking for an alternate route. Nominal wage cuts are very often a bad route by which to get to a new equilibrium.

That takes care of the error in macroeconomic reasoning, but let’s follow Pollock a bit further to get to the hypocrisy and deception.

This classic argument for inflation is of course a very old one. As Ludwig von Mises discussed clearly in 1949, the first reason for “the engineering of inflation” is: “To preserve the height of nominal wage rates…while real wage rates should rather sink.” But, he added pointedly, “neither the governments nor the literary champions of their policy were frank enough to admit openly that one of the main purposes of devaluation was a reduction in the height of real wage rates.” The current Fed is not frank enough to admit this fact either. Indeed, said von Mises, “they were anxious not to mention” this. So is the current Fed.

Nonetheless, the Fed feels it can pontificate on “inequality” and how real middle class incomes are not rising. Sure enough, with nominal wages going up 2% a year, if the Fed achieves its wish for 2% inflation, then indeed real wages will be flat. But Federal Reserve discussions of why they are flat at the very least can be described as disingenuous.

Actually, it is Pollock who is being disingenuous here. The Fed does not have a policy on real wages. Real wages are determined for the most part in free and competitive labor markets. In free and competitive labor markets, the equilibrium real wage is determined independently of the rate of inflation. Remember, there’s no Money Illusion. Minimizing nominal-wage cuts is not a policy aimed at altering equilibrium real wages, which are whatever market forces dictate, but of minimizing the costs associated with the adjustments in real wages in response to changing economic conditions.

I know that it’s always fun to quote Ludwig von Mises on inflation, but if you are going to quote Mises about how inflation is just a scheme designed to reduce real wages, you ought to at least be frank enough to acknowledge that what Mises was advocating was cutting nominal wages instead.

And it is worth recalling that even Mises recognized that nominal wages could not be reduced without limit to achieve equilibrium. In fact, Mises agreed with Keynes that it was a mistake for England in 1925 to restore sterling convertibility into gold at the prewar parity, because doing so required further painful deflation and nominal wage cuts. In other words, even Mises could understand that the path toward equilibrium mattered. Did that mean that Mises was guilty of believing in Money Illusion? Obviously not. And if the rate of deflation can matter to employment in the transition from one equilibrium to another, as Mises obviously conceded, why is it inconceivable that the rate of inflation might also matter?

So Pollock is trying to have his cake and eat it. He condemns the Fed for using inflation as a tool by which to reduce real wages. Actually, that is not what the Fed is doing, but, let us suppose that that’s what the Fed is doing, what alternative does Pollock have in mind? He won’t say. In other words, he’s the pot.

In Praise of Israel Kirzner

Published July 9, 2015 Arrow-Debrew-McKenzie model , Austrian Business-Cycle Theory , Deirdre McCloskey , general equilibrium , Hayek , Ludwig von Mises 9 Comments
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Over the holiday weekend, I stumbled across, to my pleasant surprise, the lecture given just a week ago by Israel Kirzner on being awarded the 2015 Hayek medal by the Hayek Gesellschaft in Berlin. The medal, it goes without saying, was richly deserved, because Kirzner’s long career spanning over half a century has produced hundreds of articles and many books elucidating many important concepts in various areas of economics, but especially on the role of competition and entrepreneurship (the title of his best known book) in theory and in practice. A student of Ludwig von Mises, when Mises was at NYU in the 1950s, Kirzner was able to recast and rework Mises’s ideas in a way that made them more accessible and more relevant to younger generations of students than were the didactic and dogmatic pronouncements so characteristic of Mises’s own writings. Not that there wasn’t and still isn’t a substantial market niche in which such didacticism and dogmatism is highly prized, but there are also many for whom those features of the Misesian style don’t go down quite so easily.

But it would be very unfair, and totally wrong, to think of Kirzner as a mere popularizer of Misesian doctrines. Although in his modesty and self-effacement, Kirzner made few, if any, claims of originality for himself, his application of ideas that he learned from, or, having developed them himself, read into, Mises, Kirzner’s contributions in their own way were not at all lacking originality and creativity. In a certain sense, his contribution was, in its own way, entrepreneurial, i.e., taking a concept or an idea or an analytical tool applied in one context and deploying that concept, idea, or tool in another context. It’s worth mentioning that a reverential attitude towards one’s teachers and intellectual forbears is not only very much characteristic of the Talmudic tradition of which Kirzner is also an accomplished master, but it’s also characteristic, or at least used to be, of other scholarly traditions, notably Cambridge, England, where such illustrious students of Alfred Marshall as Frederick Lavington and A. C. Pigou viewed themselves as merely elaborating on doctrines that had already been expounded by Marshall himself, Pigou having famously said of his own voluminous work, “it’s all in Marshall.”

But rather than just extol Kirzner’s admirable personal qualities, I want to discuss what Kirzner said in his Hayek lecture. His main point was to explain how, in his view, the Austrian tradition, just as it seemed to be petering out in the late 1930s and 1940s, evolved from just another variant school of thought within the broader neoclassical tradition that emerged late in the 19th century from the marginal revolution started almost simultaneously around 1870 by William Stanley Jevons in England, Carl Menger in Austria, and Leon Walras in France/Switzerland, into a completely distinct school of thought very much at odds with the neoclassical mainstream. In Kirzner’s view, the divergence between Mises and Hayek on the one hand and the neoclassical mainstream on the other was that Mises and Hayek went further in developing the subjectivist paradigm underlying the marginal-utility theory of value introduced by Jevons, Menger, and Walras in opposition to the physicalist, real-cost, theory of value inherited from Smith, Ricardo, Mill, and other economists of the classical school.

The marginal revolution shifted the focus of economics from the objective physical and technological forces that supposedly determine cost, which, in turn, supposedly determines value, to subjective, not objective, mental states or opinions that characterize preferences, which, in turn, determine value. And, as soon became evident, the new subjective marginalist theory of value implied that cost, at bottom, is nothing other than a foregone value (opportunity cost), so that the classical doctrine that cost determines value has it exactly backwards: it is really value that determines cost (though it is usually a mistake to suppose that in complex systems causation runs in only one direction).

However, as the neoclassical research program evolved, the subjective character of the underlying theory was increasingly de-emphasized, a de-emphasis that was probably driven by two factors: 1) the profoundly paradoxical nature of the idea that value determines cost, not the reverse, and b) the mathematicization of economics and the increasing adoption, in the Walrasian style, of functional representations of utility and production, leading to the construction of models of economic equilibrium that, under appropriate continuity and convexity assumptions, could be shown to have a theoretically determinate and unique solution. The false impression was created that economics was an objective science like physics, and that economics should aim to create objective and deterministic scientific representations (models) of complex economic systems that could then yield quantitatively precise predictions, in the same way that physics produced models of planetary motion yielding quantitatively precise predictions.

What Hayek and Mises objected to was the idea, derived from the functional approach to economic theory, that economics is just a technique of optimization subject to constraints, that all economic problems can be reduced to optimization problems. And it is a historical curiosum that one of the chief contributors to this view of economics was none other than Lionel Robbins in his seminal methodological work An Essay on the Nature and Significance of Economic Science, written precisely during that stage of his career when he came under the profound influence of Mises and Hayek, but before Mises and Hayek adopted the more radically subjective approach that characterizes their views in the late 1930s and 1940s. The critical works are Hayek’s essays reproduced as The Counterrevolution of Science and his essays “Economics and Knowledge,” “The Facts of the Social Sciences,” “The Use of Knowledge in Society,” and “The Meaning of Competition,” all contained in the remarkable volume Individualism and Economic Order.

What neoclassical economists who developed this deterministic version of economic theory, a version wonderfully expounded in Samuelson Foundations of Economic Analysis and ultimately embodied in the Arrow-Debreu general-equilibrium model, failed to see is that the model could not incorporate in an intellectually satisfying or empirically fruitful way the process of economic growth and development. The fundamental characteristic of the Arrow-Debreu model is its perfection. The solution of the model is Pareto-optimal, and cannot be improved upon; the entire unfolding of the model from beginning to end proceeds entirely according to a plan (actually a set of perfectly consistent and harmonious individual plans) with no surprises and no disappointments relative to what was already foreseen and planned — in detail — at the outset. Nothing is learned in the unfolding and execution of those detailed, perfectly harmonious plans that was not already known at the beginning, whatever happens having already been foreseen. If something truly new would have been learned in the course of the unfolding and execution of those plans, the new knowledge would necessarily have been surprising, and a surprise would necessarily have generated some disappointment and caused some revision of a previously formulated plan of action. But that is precisely what the Arrow-Debreu model, in its perfection, disallows. And that is what, from the perspective of Mises, Hayek, and Kirzner, is exactly wrong with the entire development of neoclassical theory for the past 80 years or more.

The specific point of the neoclassical paradigm on which Kirzner has focused his criticism is the inability of the neoclassical paradigm to find a place for the entrepreneur and entrepreneurial activity in its theoretical apparatus. Profit is what is earned by the entrepreneur, but in full general equilibrium, all income is earned by factors of production, so profits have been exhausted and the entrepreneur euthanized.

Joseph Schumpeter, who was torn between his admiration for the Walrasian general equilibrium system and his Austrian education in economics, tried to reintroduce the entrepreneur as the disruptive force behind the process of creative destruction, the role of the entrepreneur being to disrupt the harmonious equilibrium of the Walrasian system by innovating – introducing either new techniques of production or new consumer products. Kirzner, however, though not denying that disruptive Schumpeterian entrepreneurs may come on the scene from time to time, is focused on a less disruptive, but more pervasive and more characteristic type of entrepreneurship, the kind that is on the lookout for – that is alert to – the profit opportunities that are always latent in the existing allocation of resources and the current structure of input and output prices. Prices in some places or at some times may be high relative to other places and other times, so the entrepreneurial maxim is: buy cheap and sell dear.

Not so long ago, someone noticed that used book prices on Amazon are typically lower at the end of the semester or the school year, when students are trying to unload the books that they don’t want to keep, than they are at the beginning of the semester, when students are buying the books that they will have to read in the new semester. By buying the books students are selling at the end of the school year and selling them at the beginning of the school year, the insightful entrepreneur reduces the cost to students of obtaining the books they use during the school year. That bit of insight and alertness is classic Kirznerian entrepreneurship in action; it was rewarded by a profit, but the activity was equilibrating, not disruptive, reducing the spread between prices for the same, or very similar, commodities paid by buyers or received by sellers at different times of the year.

Sometimes entrepreneurship involves recognizing that a resource or a factor of production is undervalued in its current use. Shifting the resource from a relatively low-valued use to a higher-value use generates a profit for the alert entrepreneur. Here, again, the activity is equilibrating not disruptive. And as others start to catch on, the profit earned on the spread between the value of the resource in its old and new uses will be eroded by the competition of copy-cat entrepreneurs and of other entrepreneurs with an even better idea derived from an even more penetrating insight.

Here is another critical point. Rarely does a new idea come into existence and cause just one change. Every change creates a new and different situation, potentially creating further opportunities to be taken advantage of by other alert and insightful individuals. In an open competitive system, there is no reason why the process of discovery and adaptation should ever come to an end state in which new insights can no longer be made and change is no longer possible.

However, it also the case that knowledge or information is often imperfect and faulty, and that incentives are imperfectly aligned with actual benefits, so that changes can be profitable even though they lead to inferior outcomes. Margarine can be substituted for butter, and transfats for saturated fats. Big mistake. But who knew? And processed carbohydrates can replace fats in low-fat diets. Big mistake. But who knew?

I myself had the pleasure of experiencing first-hand, on a very small scale to be sure, but still in a very inspiring way, this sort of unplanned, serendipitous connection between my stumbling across Kirzner’s Hayek lecture and, then, after starting to write this post a couple of days ago, doing a Google search on Kirzner plus something else (can’t remember what) and seeing a link to Deirdre McCloskey’s paper “A Kirznerian Economic History of the Modern World” in which McCloskey, in somewhat over-the-top style, waxed eloquent about the long and circuitous evolution of her views from the strict neoclassicism in which she was indoctrinated at Harvard and later at Chicago to Kirznerian Austrianism. McCloskey observes in her wonderful paean to Kirzner that growth theory (which is now the core of modern macroeconomics) is utterly incapable of accounting for the historically unique period of economic growth over the past 200 years in what we now refer to as the developed world.

I had faced repeatedly 1964 to 2010 the failure of oomph in the routine, Samuelsonian arguments, such as accumulation inspired by the Protestant ethic, or trade as an engine of growth, or Marxian exploitation, or imperialism as the last stage of capitalism, or factor-biased induced technical change, or Unified Growth Theory. My colleagues at the University of Chicago in the 1970s, Al Harberger and Bob Fogel, pioneered the point that Harberger Triangles of efficiency gain are small (Harberger 1964; Fogel 1965). None of the allocative, capital-accumulation explanations of economic growth since Adam Smith have worked scientifically, which I show in depressing detail in Bourgeois Dignity. None of them have the quantitative force and the distinctiveness to the modern world and the West to explain the Great Fact. No oomph.

What works? Creativity. Innovation. Discovery. The Austrian core. And where did discovery come from? It came from the releasing of the West from ancient constraints on the dignity and liberty of the bourgeoisie, producing an intellectual and engineering explosion of ideas. As the banker and science writer Matt Ridley has recently described it (2010; compare Storr 2008), ideas started breeding, and having baby ideas, who bred further. The liberation of the Jews in the West is a good emblem for the wider story. A people of the book began to be allowed into commercial centers in Holland and then England, and allowed outside the shtetl and the ghetto, and into the universities of Berlin and Manchester. They commenced innovating on a massive, breeding-reactor scale, in good ways (Rothschild, Einstein) and in bad (Marx, Freud).

Ridley explains how the evolutionary biologist Leigh Van Valen proposed in 1973 a Red Queen Hypothesis that would explain why commercial and mechanical ideas, when first allowed to evolve, had to run faster and faster to stay in the same place. Economists would call it the dissipation of initial rents, in the second and third acts of the economic drama. Once breeding ideas were set free in the seventeenth century they created more and more opportunities for Kirznerian alertness. The opportunities were alertly taken up, and persuasively argued for, and at length routinized. The idea of the steam engine had babies with the idea of rails and the idea of wrought iron, and the result was the railroads. The new generation of ideas-in view of the continuing breeding of ideas going on in the background-created by their very routinization still more Kirznerian opportunities. Railroads once they were routine led to Sears, Roebuck and Montgomery Ward. And the routine then created prosperous people, such as my grandfather the freight conductor on the Milwaukee Road or my great-grandfather the postal clerk on the Chicago & Western Indiana or my other great-grandfather who invented the ring on telephones (which extended the telegraph, which itself had made tight scheduling of trains possible). Some became prosperous enough to take up the new ideas, and all became prosperous enough under the Great Fact to buy them. If there was no dissipation of the rents to alertness, and no ultimate gain of income to hoi polloi, no third act, no Red Queen effect, then innovation would not have a justification on egalitarian grounds-as in the historical event it surely did have. The Bosses would engorge all the income, as Ricardo in the early days of the Great Fact had feared. But in the event the discovery of which Kirzner and the Austrian tradition speaks enriched in the third act mainly the poor-your ancestors, and Israel’s, and mine.

It is the growth and diffusion of knowledge (both practical and theoretical, but especially the former), not the accumulation of capital, that accounts for the spectacular economic growth of the past two centuries. So, all praise to the Austrian economist par excellence, Israel Kirzner. But just to avoid any misunderstanding, I will state for the record, that my admiration for Kirzner does not mean that I have gone wobbly on the subject of Austrian Business Cycle Theory, a subject on which Kirzner has been, so far as I know, largely silent — yet further evidence – as if any were needed — of Kirzner’s impeccable judgment.

Mises’s Unwitting Affirmation of the Hawtrey-Cassel Explanation of the Great Depression

Published July 3, 2015 Bank of France , Federal Reserve , gold standard , gold-exchange standard , Great Depression , Ludwig von Mises 12 Comments
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In looking up some sources for my previous post on the gold-exchange standard, I checked, as I like to do from time to time, my old copy of The Theory of Money and Credit by Ludwig von Mises. Mises published The Theory of Money and Credit in 1912 (in German of course) when he was about 31 years old, a significant achievement. In 1924 he published a second enlarged edition addressing many issues that became relevant in the aftermath the World War and the attempts then underway to restore the gold standard. So one finds in the 1934 English translation of the 1924 German edition a whole section of Part III, chapter 6 devoted to the Gold-Exchange Standard. I noticed that I had dog-eared the section, which presumably means that when I first read the book I found the section interesting in some way, but I did not write any notes in the margin, so I am not sure what it was that I found interesting. I can’t even remember when I read the book, but there are many passages underlined throughout the book, so I am guessing that I did read it from cover to cover. Luckily, I wrote my name and the year (1971) in which I bought the book on the inside of the front cover, so I am also guessing that I read the book before I became aware of the Hawtrey Cassel explanation of the Great Depression. But it seems clear to me that whatever it was that I found interesting about the section on the gold-exchange standard, it didn’t make a lasting impression on me, because I don’t think that I ever reread that section until earlier this week. So let’s go through Mises’s discussion and see what we find.

Wherever inflation has thrown the monetary system into confusion, the primary aim of currency policy has been to bring the printing presses to a standstill. Once that is done, once it has at last been learned that even the policy of raising the objective exchange-value of money has undesirable consequences, and once it is seen that the chief thing is to stabilize the value of money, then attempts are made to establish a gold-exchange standard as quickly as possible.

This seems to be reference to the World War I inflation and the somewhat surprising post-war inflation of 1919, which caused most countries to want to peg their currencies against the dollar, then the only major country with a currency convertible into gold. Mises continues:

This, for example, is what occurred in Austria at the end of 1922 and since then, at least for the time being, the dollar rate in that country has been fixed. But in existing circumstances, invariability of the dollar rate means invariability of the price of gold also. Thus Austria has a dollar-exchange standard and so, indirectly, a gold-exchange standard. That is the currency system that seems to be the immediate aim in Germany, Poland, Hungary, and many other European countries. Nowadays, European aspirations in the sphere of currency policy are limited to a return to the gold standard. This is quite understandable, for the gold standard previously functioned on the whole satisfactorily; it is true that it did not secure the unattainable ideal of a money with an invariable objective exchange value, but it did preserve the monetary system from the influence of governments and changing policies.

Yet the gold-standard system was already undermined before the war. The first step was the abolition of the physical use of gold in individual payments and the accumulation of the stocks of gold in the vaults of the great banks-of-issue. The next step was the adoption of the practice by a series of States of holding the gold reserves of the central banks-of-issue (or the redemption funds that took their place), not in actual gold, but in various sorts of foreign claims to gold. Thus it came about that the greater part of the stock of gold that was used for monetary purposes was gradually accumulated in a few large banks-of-issue; and so these banks became the central reserve-banks of the world, as previously the central banks-of-issue had become central reserve-banks for individual countries.

Mises is leaving out a lot here. Many countries were joining gold standard in the last quarter of the 19th century, when the gold standard became an international system. The countries adopting the gold standard did not have a gold coinage; for them to introduce a gold coinage, as Mises apparently would have been wanted, was then prohibitively costly. But gold reserves were still piling up in many central banks because of laws and regulations requiring central banks to hold gold reserves against banknotes. If gold coinages would have been introduced in addition to the gold gold reserves being accumulated as reserves against banknotes, the spread of gold standard through much of the world in the last quarter of the 19th century would have drastically accentuated the deflationary trends that marked most of the period from 1872 to 1896.

The War did not create this development; it merely hastened it a little.

Actually a lot. But we now come to the key passage.

Neither has the development yet reached the stage when all the newly-produced gold that is not absorbed into industrial use flows to a single centre. The Bank of England and the central banks-of-issue of some other States still control large stocks of gold; there are still several of them that take up part of the annual output of gold. Yet fluctuations in the price of gold are nowadays essentially dependent on the policy followed by the Federal Reserve Board. If the United States did not absorb gold to the extent to which it does, the price of gold would fall and the gold-prices of commodities would rise. Since, so long as the dollar represents a fixed quantity of gold, the United States admits the surplus gold and surrenders commodities for gold to an unlimited extent, a rapid fall in the value of gold has hitherto been avoided.

Mises’s explanation here is rather confused, because he neglects to point out that the extent to which gold was flowing into the Federal Reserve was a function, among other things, of the credit policy adopted by the Fed. The higher the interest rate, the more gold would flow into the Fed and, thus, the lower the international price level. Mises makes it sound as if there was a fixed demand for gold by the rest of the world and the US simply took whatever was left over. That was a remarkable misunderstanding on Mises’s part.

But this policy of the United States, which involves considerable sacrifices, might one day be changed. Variations in the price of gold would then occur and this would be bound to give rise in other gold countries to the question of whether it would not be better in order to avoid further rises in prices to dissociate the currency standard from gold.

Note the ambiguous use of the term “price of gold.” The nominal price of gold was fixed by convertibility, so what Mises meant was the real price of gold, with a fixed nominal price. It would have been less ambiguous if the term “value of gold” had been used here and in the rest of the passage instead of “price of gold.” I don’t know if Mises or his translator was at fault.

Just as Sweden attempted for a time to raise the krone above its old gold parity by closing the Mint to gold, so other countries that are now still on the gold standard or intend to return to it might act similarly. This would mean a further drop in the price of gold and a further reduction of the usefulness of gold for monetary purposes. If we disregard the Asiatic demand for money, we might even now without undue exaggeration say that gold has ceased to be a commodity the fluctuations in the price of which are independent of government influence. Fluctuations in the price of gold are nowadays substantially dependent on the behaviour of one government, viz. that of the United States of America.

By George, he’s got it! The value of gold depends mainly on the Fed! Or, to be a bit more exact, on how much gold is being held by the Fed and by the other central banks. The more gold they hold, the more valuable in real terms gold becomes, which means that, with a fixed nominal price of gold, the lower are the prices of all other commodities. The point of the gold-exchange standard was thus to reduce the world’s monetary demand for gold, thereby limiting the tendency of gold to appreciate and for prices in terms of gold to fall. Indeed, Mises here cites in a footnote none other than the villainous John Maynard Keynes himself (Tract on Monetary Reform) where he also argued that after World War I, the value of gold was determined by government policy, especially that of the Federal Reserve. Mises goes on to explain:

All that could not have been foreseen in this result of a long process of development is the circumstance that the fluctuations in the price of gold should have become dependent upon the policy of one government only. That the United States should have achieved such an economic predominance over other countries as it now has, and that it alone of all the countries of great economic importance should have retained the gold standard while the others (England, France, Germany, Russia, and the rest) have at least temporarily abandoned it – that is a consequence of what took place during the War. Yet the matter would not be essentially different if the price of gold was dependent not on the policy of the United States alone, but on those of four or five other governments as well. Those protagonists of the gold-exchange standard who have recommended it as a general monetary system and not merely as an expedient for poor countries, have overlooked this fact. They have not observed that the gold-exchange standard must at last mean depriving gold of that characteristic which is the most important from the point of view of monetary policy – its independence of government influence upon fluctuations in its value. The gold-exchange standard has not been recommended or adopted with the object of dethroning gold. All that Ricardo wanted was to reduce the cost of the monetary system. In many countries which from the last decade of the nineteenth century onward have wished to abandon the silver or credit-money standard, the gold-exchange standard rather than a gold standard with an actual gold currency has been adopted in order to prevent the growth of a new demand for gold from causing a rise in its price and a fall in the gold-prices of commodities. But whatever the motives may have been by which the protagonists of the gold-exchange standard have been led, there can be no doubt concerning the results of its increasing popularity.

If the gold-exchange standard is retained, the question must sooner or later arise as to whether it would not be better to substitute for it a credit-money standard whose fluctuations were more susceptible to control than those of gold. For if fluctuations in the price of gold are substantially dependent on political intervention, it is inconceivable why government policy should still be restricted at all and not given a free hand altogether, since the amount of this restriction is not enough to confine arbitrariness in price policy within narrow limits. The cost of additional gold for monetary purposes that is borne by the whole world might well be saved, for it no longer secures the result of making the monetary system independent of government intervention. If this complete government control is not desired, there remains one alternative only: an attempt must be made to get back from the gold-exchange standard to the actual use of gold again.

Thus, we see that in 1924 none other than the legendary Ludwig von Mises was explaining that the value of gold had come to depend primarily on the policy decisions of the Federal Reserve and the other leading central banks. He also understood that a process of deflation could have terrible consequences if free-market forces were not operating to bring about an adjustment of market prices to the rising value of gold. Recognizing the potentially disastrous consequences of a scramble for gold by the world’s central banks as they rejoined the gold standard, Hawtrey and Cassel called for central-bank cooperation to limit the increase in the demand for gold and to keep the value of gold stable. In 1924, at any rate, Mises, too, recognized that there could be a destabilizing deflationary increase in the demand for gold by central banks. But when the destabilizing deflationary increase actually started to happen in 1927 when the Bank of France began cashing in its foreign-exchange reserves for gold, triggering similar demands by other central banks in the process of adopting the gold standard, the gold standard started collapsing under the weight  of deflation. But, as far as I know, Mises never said a word about the relationship between gold demand and the Great Depression.

Instead, in the mythology of Austrian business-cycle theory, it was all the fault of the demonic Benjamin Strong for reducing the Fed’s discount rate from 5% to 3.5% in 1927 (and back to only 4% in 1928) and of the duplicitous Montagu Norman for reducing Bank Rate from 5% to 4.5% in 1927-28 rather than follow the virtuous example of the Bank of France in abandoning the cursed abomination of the gold-exchange standard.

Ludwig von Mises Explains (and Solves) Market Failure

Published November 16, 2014 Hayek , Ludwig von Mises 20 Comments
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Last week Major Freedom, a relentless and indefatigable web-Austrian troll – and with a name like that, I predict a bright future for him as a professional wrestler should he ever tire of internet trolling — who regularly occupies Scott Sumner’s blog, responded to a passing reference by Scott to F. A. Hayek’s support for NGDP targeting with an outraged rant against Hayek, calling Hayek a social democrat, a description of Hayek that for some reason brought to my mind Saul Steinberg’s famous New Yorker cover showing what the world looks like from 9th Avenue in Manhattan.

saul_steinberg_newyorker

Hayek was not a libertarian by the way. He was a social democrat. If you read his works closely, you’ll realize he was politically leftist very soon after his earlier economics works. Hayek was actually an economist for only a short period of time. He soon became disenchanted with free market economics, and delved into sociology where his works were all heavily influenced by leftist politics. He was an ardent critic of government, but not because he was anti-government, but because the present day governments were not his ideal.

Hayek favored central banks preventing NGDP from falling yes, but he was a contradictory writer. It is dishonest to only focus on the one side of the contradiction that supports your own ideology. If you were honest, you would make it a point that Hayek also favored monetary denationalization, of competitive free market currencies. He wrote a book on that for crying out loud. His contradictions are “Hayekian.” NGDP targeting is merely the Dr. Jekyll to his Mr. Hyde.

Then responding to the incredulity of another commenter at his calling Hayek a social democrat, the Major let loose this barrage:

From [Hans-Hermann] Hoppe:

According to Hayek, government is “necessary” to fulfill the following tasks: not merely for “law enforcement” and “defense against external enemies” but “in an advanced society government ought to use its power of raising funds by taxation to provide a number of services which for various reasons cannot be provided, or cannot be provided adequately, by the market.” (Because at all times an infinite number of goods and services exist that the market does not provide, Hayek hands government a blank check.)

Among these goods and services are:

“…protection against violence, epidemics, or such natural forces as floods and avalanches, but also many of the amenities which make life in modern cities tolerable, most roads … the provision of standards of measure, and of many kinds of information ranging from land registers, maps and statistics to the certification of the quality of some goods or services offered in the market.”

Additional government functions include “the assurance of a certain minimum income for everyone”; government should “distribute its expenditure over time in such a manner that it will step in when private investment flags”; it should finance schools and research as well as enforce “building regulations, pure food laws, the certification of certain professions, the restrictions on the sale of certain dangerous goods (such as arms, explosives, poisons and drugs), as well as some safety and health regulations for the processes of production; and the provision of such public institutions as theaters, sports grounds, etc.”; and it should make use of the power of “eminent domain” to enhance the “public good.”

Moreover, it generally holds that “there is some reason to believe that with the increase in general wealth and of the density of population, the share of all needs that can be satisfied only by collective action will continue to grow.”

Further, government should implement an extensive system of compulsory insurance (“coercion intended to forestall greater coercion”), public, subsidized housing is a possible government task, and likewise “city planning” and “zoning” are considered appropriate government functions — provided that “the sum of the gains exceed the sum of the losses.” And lastly, “the provision of amenities of or opportunities for recreation, or the preservation of natural beauty or of historical sites or scientific interest … Natural parks, nature-reservations, etc.” are legitimate government tasks.

In addition, Hayek insists we recognize that it is irrelevant how big government is or if and how fast it grows. What alone is important is that government actions fulfill certain formal requirements. “It is the character rather than the volume of government activity that is important.” Taxes as such and the absolute height of taxation are not a problem for Hayek. Taxes — and likewise compulsory military service — lose their character as coercive measures,

“…if they are at least predictable and are enforced irrespective of how the individual would otherwise employ his energies; this deprives them largely of the evil nature of coercion. If the known necessity of paying a certain amount of taxes becomes the basis of all my plans, if a period of military service is a foreseeable part of my career, then I can follow a general plan of life of my own making and am as independent of the will of another person as men have learned to be in society.”

But please, it must be a proportional tax and general military service!

The disgust felt by the Major for the crypto-statist Hayek is palpable, reminiscent of Ayn Rand’s pathological abhorrence of Hayek for tolerating welfare-statism. Ah, but Ludwig von Mises, there is a man after the Major’s very own heart.

In distinct contrast, how refreshingly clear — and very different — is Mises! For him, the definition of liberalism can be condensed into a single term: private property. The state, for Mises, is legalized force, and its only function is to defend life and property by beating antisocial elements into submission. As for the rest, government is “the employment of armed men, of policemen, gendarmes, soldiers, prison guards, and hangmen. The essential feature of government is the enforcement of its decrees by beating, killing, and imprisonment. Those who are asking for more government interference are asking ultimately for more compulsion and less freedom.”

Moreover (and this is for those who have not read much of Mises but invariably pipe up, “but even Mises is not an anarchist”), certainly the younger Mises allows for unlimited secession, down to the level of the individual, if one comes to the conclusion that government is not doing what it is supposed to do: to protect life and property.

Well, the remark about Hayek’s support for — perhaps acquiescence in would be a better description — conscription (see the Constitution of Liberty) reminded me that in Human Action no less – for the uninitiated that’s Mises’s magnum opus, a 900+ page treatise on economics and praxeology — Mises himself weighed in on the issue of military conscription.

From this point of view one has to deal with the often-raised problem of whether conscription and the levy of taxes mean a restriction of freedom. If the principles of the market economy were acknowledged by all people all over the world, there would not be any reason to wage war and the individual states could live in undisturbed peace. But as conditions are in our age, a free nation is continually threatened by the aggressive schemes of totalitarian autocracies. If it wants to preserve its freedom, it must be prepared to defend its independence. If the government of a free country forces every citizen to cooperate fully in its designs to repel the aggressors and every able-bodied man to join the armed forces, it does not impose upon the individual a duty that would step beyond the tasks the praxeological law dictates. In a world full of unswerving aggressors and enslavers, integral unconditional pacifism is tantamount to unconditional surrender to the most ruthless oppressors. He who wants to remain free, must fight unto death those who are intent upon depriving him of his freedom. As isolated attempts on the part of each individual to resist are doomed to failure, the only workable way is to organize resistance by the government. The essential task of government is defense of the social system not only against domestic gangsters but also against external foes. He who in our age opposes armaments and conscription is, perhaps unbeknown to himself, an abettor of those aiming at the enslavement of all.

There it is. With characteristic understatement, Ludwig von Mises, a card-carrying member of the John Birch Society listed on the advisory board of the Society’s flagship publication American Opinion during the 1960s, calls anyone opposed to conscription an abettor of those aiming at the enslavement of all. But what I find interesting in Mises’s diatribe are the two sentences before the last one in the paragraph.

He who wants to remain free, must fight unto death those who are intent upon depriving him of his freedom. As isolated attempts on the part of each individual to resist are doomed to failure, the only workable way is to organize resistance by the government.

Here Mises says that we have to defend ourselves to maintain our freedom, otherwise we will be enslaved. OK. And then he says that voluntary self-defense will not work. Why won’t it work? Because the market isn’t working. And what causes the market to fail? “Isolated attempts on the part of each individual to resist” will fail. In other words, defense is a public good. People will free ride on the efforts of others. But Mises has the solution. Impose a draft, and compel the able-bodied to defend the homeland and force everyone to pay taxes to finance the provision of the public good, which the unhampered free market is unable to do on its own. Of course, this is just one example of market failure, but Mises doesn’t actually explain why the provision of national defense is the only public good. But, analytically of course, there is no distinction between national defense and other public goods, which confer benefits on people irrespective of whether they have paid for the good. So Mises acknowledges that there is such a thing as a public good, and supports the use of government coercion to supply the public good, but without providing any criterion for which public goods may be provided by the government and which may not. If conscription can be justified to solve a certain kind of public-good problem, why is it unthinkable to rely on taxation to solve other kinds of public-good problems, whose existence Mises, apparently unbeknown to himself, has implicitly conceded?

With the logical rigor that his acolytes find so compelling, Mises concludes this particular diatribe with the following pronouncement:

Every step a government takes beyond the fulfillment of its essential functions of protecting the smooth operation of the market economy against aggression, whether on the part of domestic or foreign disturbers, is a step forward on a road that directly leads into the totalitarian system where there is no freedom at all.

Let’s think about that one. “Every step a government takes beyond the fulfillment of its essential function of protecting the smooth operation of the market economy against aggression . . . is a step forward on a road that leads into the totalitarian system where there is no freedom at all.” Pretty scary words, but how logically compelling is this apodictally certain praxeological law?

Well, I live in Montgomery County, Maryland, a short distance from US Route 29. When I visit Baltimore about 35 miles from my home, I often come back from Baltimore via Interstate 70 which starts at a park-and-ride station near Baltimore and continues for about 2153 miles to Cove Fort, Utah. I am happy to report that I have never once driven from Baltimore to Cove Fort. In fact the first exit off of Interstate 70 puts me on US Route 29. What’s more, even if I miss the exit for Route 29, as I have done occasionally, there are other exits further down the highway that allow me to get to Route 29; just because I drive the first four miles on Interstate 70 from Baltimore, it doesn’t necessarily follow that I will wind up in Cove Fort, Utah. So this particular example of the supposedly impeccable Misesian logic sure seems like a non-sequitur to me.

 

On the Unsustainability of Austrian Business-Cycle Theory, Or How I Discovered that Ludwig von Mises Actually Rejected His Own Theory

Published October 10, 2012 Bob Murphy , gold standard , Ludwig von Mises , monetary policy 67 Comments

Robert Murphy, a clever fellow with an excessive, but, to his credit, not entirely uncritical (see here and here), devotion to Austrian Business Cycle Theory (ABCT), criticized my previous post about ABCT. Murphy’s criticism focuses on my alleged misreading or misrepresentation of Mises’s original version of ABCT in his The Theory of Money and Credit. (Note, however, that we are both dealing with the 1934 translation of the revised 1924 edition, not the original 1912 German text.)

Murphy quotes the following passage from my post focusing especially on the part in bold print.

[T]he notion of unsustainability [in Austrian business cycle theory] is itself unsustainable, or at the very least greatly exaggerated and misleading. Why must the credit expansion that produced the interest-rate distortion or the price bubble come to an end? Well, if one goes back to the original sources for the Austrian theory, namely Mises’s 1912 book The Theory of Money and Credit and Hayek’s 1929 book Monetary Theory and the Trade Cycle, one finds that the effective cause of the contraction of credit is not a physical constraint on the availability of resources with which to complete the investments and support lengthened production processes, but the willingness of the central bank to tolerate a decline in its gold holdings. It is quite a stretch to equate the demand of the central bank for a certain level of gold reserves with a barrier that renders the completion of investment projects and the operation of lengthened production processes impossible, which is how Austrian writers, fond of telling stories about what happens when someone tries to build a house without having the materials required for its completion, try to explain what “unsustainability” means.

The original Austrian theory of the business cycle was thus a theory specific to the historical conditions associated with classical gold standard.

Murphy then chastises me for not having read or having forgotten the following statement by von Mises.

Painful consideration of the question whether fiduciary media really could be indefinitely augmented without awakening the mistrust of the public would be not only supererogatory, but otiose.

Now it’s true that I did not recall this particular passage when writing my post, but the passage is not inconsistent with the point I was making. If you look at the passage from section 4 of chapter 5 of Part III of The Theory of Money and Credit (p. 357 of the 1934 edition), you will see that the context in which the statement is written is a hypothetical example in which banks can engage in an unlimited credit expansion without the constraints of an internal or external drain on their balance sheets. So while it is true that Mises anticipated in The Theory of Money and Credit the question whether a banking system not constrained by any internal or external drains could engage in an unlimited credit expansion, Mises was engaged in a hypothetical exercise, not the analysis of any business cycle ever encountered.

Murphy provides two longer quotations from a bit later in the same chapter in which Mises tried to explain why an unlimited credit expansion would be unsustainable:

The situation is as follows: despite the fact that there has been no increase of intermediate products and there is no possibility of lengthening the average period of production, a rate of interest is established in the loan market which corresponds to a longer period of production; and so, although it is in the last resort inadmissible and impracticable, a lengthening of the period of production promises for the time to be profitable. But there cannot be the slightest doubt as to where this will lead. A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods. This time must come all the more quickly inasmuch as the fall in the rate of interest weakens the motive for saving and so slows up the rate of accumulation of capital. The means of subsistence will prove insufficient to maintain the labourers during the whole period of the process of production that has been entered upon. Since production and consumption are continuous, so that every day new processes of production are started upon and others completed, this situation does not imperil human existence by suddenly manifesting itself as a complete lack of consumption goods; it is merely expressed in a reduction of the quantity of goods available for consumption and a consequent restriction of consumption. The market prices of consumption goods rise and those of production goods fall. (p. 362)

And

If our doctrine of crises is to be applied to more recent history, then it must be observed that the banks have never gone as far as they might in extending credit and expanding the issue of fiduciary media. They have always left off long before reaching this limit, whether because of growing uneasiness on their own part and on the part of all those who had not forgotten the earlier crises, or whether because they had to defer to legislative regulations concerning the maximum circulation of fiduciary media. And so the crises broke out before they need have broken out. It is only in this sense that we can interpret the statement that it is apparently true after all to say that restriction of loans is the cause of economic crises, or at least their immediate impulse; that if the banks would only go on reducing the rate of interest on loans they could continue to postpone the collapse of the market. If the stress is laid upon the word postpone, then this line of argument can be assented to without more ado. 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. (p. 365)

The latter quotation actually confirms my assertion that Mises’s theory of business cycles as a historical phenomenon was a theory of the effects a credit expansion brought to a close by an external constraint imposed on the banks by the gold standard or perhaps by some artificial legal constraint on the reserve holdings of the banks. It is true that Mises hypothesized that a credit expansion by a completely unconstrained banking system was inevitably destined to be unsustainable, but this is a purely theoretical argument disconnected from historical experience.

But that is just what I said in my post:

[D]espite their antipathy to proposals for easing the constraints of the gold standard on individual central banks, Mises and Hayek never succeeded in explaining why a central-bank expansion necessarily had to be stopped. Rather than provide such an explanation they instead made a different argument, which was that the stimulative effect of a central-bank expansion would wear off once economic agents became aware of its effects and began to anticipate its continuation. This was a fine argument, anticipating the argument of Milton Friedman and Edward Phelps in the late 1960s by about 30 or 40 years. But that was an argument that the effects of central-bank expansion would tend to diminish over time as its effects were anticipated. It was not an argument that the expansion was unsustainable.

So let’s go back to what Mises said in the middle quotation above, where he tries to do the heavy lifting.

[D]espite the fact that there has been no increase of intermediate products and there is no possibility of lengthening the average period of production, a rate of interest is established in the loan market which corresponds to a longer period of production; and so, although it is in the last resort inadmissible and impracticable, a lengthening of the period of production promises for the time to be profitable.

I don’t understand why there has been no increase in intermediate products. The initial monetary expansion causes output to increase temporarily, allowing the amount of intermediate products to increase, and the average period of production to lengthen.

But there cannot be the slightest doubt as to where this will lead.

Note the characteristic Misesian rhetorical strategy: proof by assertion. There cannot be the slightest doubt that I am right and you are wrong. QED. Praxeology in action!

A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods.

Are the means of subsistence a common property resource? When property rights don’t exist over resources, those resources run out. The means of subsistence are owned and they are sold, not given away or taken at will. As their supply dwindles, their prices rise and consumption is restricted.

This time must come all the more quickly inasmuch as the fall in the rate of interest weakens the motive for saving and so slows up the rate of accumulation of capital.

But the whole point is that monetary expansion is raising the prices of consumption goods thereby imposing forced saving on households to accommodate the additional investment.

The means of subsistence will prove insufficient to maintain the labourers during the whole period of the process of production that has been entered upon.

What does this mean? Are workers dying of starvation? Is Mises working with a Ricardian subsistence theory of wages? But wait; let’s read on.

Since production and consumption are continuous, so that every day new processes of production are started upon and others completed, this situation does not imperil human existence by suddenly manifesting itself as a complete lack of consumption goods; it is merely expressed in a reduction of the quantity of goods available for consumption and a consequent restriction of consumption. The market prices of consumption goods rise and those of production goods fall.

OK, so what is the point? What is unsustainable about this?

Now I am really confused.  But wait!  Look at the preceding paragraph, and read the following:

Now it is true that an increase of fiduciary media brings about a redistribution of wealth in the course of its effects on the objective exchange value of money which may well lead to increased saving and a reduction of the standard of living. A depreciation of money, when metallic money is employed, may also lead directly to an increase in the stock of goods in that it entails a diversion of some metal from monetary to industrial uses. So far as these factors enter into consideration, an increase of fiduciary media does cause a diminution of even the natural rate of interest, as we could show if it were necessary. But the case that we have to investigate is a different one. We are not concerned with a reduction in the natural rate of interest brought about by an increase in the issue of fiduciary media, but with a reduction below this rate in the money rate charged by the banks, inaugurated by the credit-issuing banks and necessarily followed by the rest of the loan market. The power of the banks to do such a thing has already been demonstrated. (pp. 361-62)

So von Mises actually conceded that monetary expansion by the banks could reduce the real rate of interest via the imposition of forced savings caused by a steady rate of inflation. Unsustainability results only when the central bank reduces the rate of interest below the natural rate and succeeds in keeping it permanently below the natural rate. The result is hyperinflation, which almost everyone agrees is unsustainable. We don’t need ABCT to teach us that!  But the question that I and most non-Austrian economists are interested in is whether there is anything unsustainable about a steady rate of monetary expansion associated with a steady rate of growth in NGDP.  Answer: not obviously. And, evidently, even the great Ludwig von Mises, himself, admitted that a steady monetary expansion is indeed sustainable.  You can look it up.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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