
in Brian Snowdon and Howard R. Vane
Modern Macroeconomics: Its Origins, Developmient and Current State
Aldershot: Edward Elgar, 2005
Also available as a .pdf file
Chapter 9: The Austrian School: Capital-Based Macroeconomics
Roger W. Garrison
Mr. Keynes's aggregates conceal the most fundamental
mechanisms of change. (Hayek, 1931)
9.1 The Mengerian Vision
The Austrian school is best known for its microeconomics and, in particular,
for its role in the marginalist revolution. In the early 1870s, Carl Menger,
along with French economist Léon Walras and English economist William
Stanley Jevons, reoriented value theory by calling attention to the marginal
unit of a good as key to our understanding the determination of the good’s
market price. With marginality central to the analysis, microeconomics
was forever changed. It is less widely recognized, however, that a viable
macroeconomic construction also arises quite naturally out of the marginalist
revolution in the context of Menger’s vision of a capital-using market
economy.
Modern macroeconomics
makes a distinction between factor markets (inputs) and product markets
(outputs). Intermediate inputs and outputs are rarely in play. By contrast,
the economics of the Austrian school features a production process—a
sequence of activities in which the outputs associated with some activities
feed in as inputs to subsequent activities. The eventual yield of consumable
output constitutes the end of the sequence. Menger (1981 [1871]) set out
the theory in terms of “orders of goods,” the first, or lowest, order
constituting consumer goods and second, third, and higher orders constituting
producers goods increasingly remote in time from goods of the lowest order.
Eugen
von Böhm-Bawerk (1959 [1889]) introduced the similar notion of “maturity
classes” to capture this temporal element in the economy's production
process. He stressed the point that an increase in the economy’s growth
rate must entail an increase in activity in the earlier maturity classes
relative to (concurrent) activity in the later maturity classes.
Böhm-Bawerk
was possibly the first economist to insist that propositions about the
macroeconomy have firm microeconomic foundations. In an 1895 essay, he
wrote that “One cannot eschew studying the microcosm if one wants to
understand properly the macrocosm of a developed economy” (Hennings,
1997, p.74). Ludwig von Mises (1953 [1912]),
who is generally credited for using marginal utility analysis to account
for the value of money, was also the first to recognize the significance
of credit creation in the context of a decentralized, time-consuming production
process. The capital theory originated by Menger and the theory of money
and credit set out by Mises was developed by Friedrich
Hayek (1967 [1935]) into the Austrian theory of the business cycle.
Lionel Robbins (1971 [1934]) and Murray Rothbard (1963) applied the theory
to the interwar episode of boom and bust. Eventually, the insights of these
and other Austrians gave rise to a full-fledged capital-based macroeconomics
(Horwitz, 2000 and
Garrison,
2001).
9.2 The Intertemporal Structure of Capital
Hayek greatly simplified the Austrian vision of a capital-using economy
by modeling the economy’s production activities as a sequence of inputs
and a point output. Each element in the sequence is designated a “stage
of production,” the number of stages posited being largely a matter of
pedagogical convenience. This simple construction was first introduced
as a bar chart with the individual bars arrayed temporally, their (equal)
widths representing increments of production time. The length of the final
bar represents the value of consumable output; the attenuated lengths of
the preceding bars represent the values of the goods in process at the
various stages of production.
Figure 9.1 shows
ten stages of production arrayed from left to right. (In the original Hayekian
rendition, five stages were arrayed from top to bottom.) The specific number
of stages is not intended to quantify any actual, empirically established
detail about the economy’s production process but rather to capture
our general understanding that in many instances the (intermediate) output
of one stage is used as an input to a subsequent stage. That is, vertical
integration—and, certainly, complete vertical integration—is not the
norm. Hayek’s “stages” do not translate cleanly into “firms”
or “industries.” Some vertically integrated activities may be carried
out within a single firm. An oil company, for example, may be engaged in
exploring, extracting, refining, distributing, and retailing. A paper manufacturer,
for another example, may be supplying paper for blueprints and for greeting
cards, thus operating simultaneously in different stages. And there are
obvious deviations from the strict one-way temporal sequence: Coal may
be used in the production of steel while steel is used in the production
of coal. (This is the supposedly telling counter-example offered by Frank
Knight in his critical introduction to the English translation of Menger’s
Principles.)
Still, as with all simple models, this Austrian model of the capital structure
is notable not for its many sins of omission but rather for the essential
truths that are captured by its construction.
Means are employed
to achieve ends, and those means are temporally prior to the corresponding
ends. Production moves forward through time. Valuation, however, emanates
in the reverse direction. That is, the anticipated value of an end attaches
itself to the means capable of achieving that end. This is Menger’s Law.
The demand for the factors of production and hence for the outputs of the
intermediate stages of production is a derived demand. The direction of
valuation is implicit in Menger’s designation of consumption goods as
“goods of the first order.” The market values of goods of the
second, third, and higher orders are ultimately derived from the anticipated
value of the first-order goods. But even with the doctrine of derived demand
fully in play, those values entail a systematic time discount consistent
with the temporal remoteness of higher-order goods.
The Austrian
vision puts the entrepreneur in a key role. At a minimum, the entrepreneur
operating in some particular stage of production must anticipate the demand
for his own output, assessing the profitability of his activities with
due attention to the cost of borrowed funds. Longer-run planning may require
gauging the strength of demand several stages forward, including ultimately
the demand for the consumable output. Speculative activities may consist
in part in the movement of resources—in response to a change in credit
conditions—from one stage to another and possibly in the creation of
new stages of production that are of a higher order than the highest order
of the existing stages. The increasing “roundaboutness,” to use Bohm-Bawerk’s
term, and the increasing significance of the time element in the production
process are characteristic of developing (and developed) capitalist economies.
The attention
to the temporal structure of production suggests that the time element
is an important variable in our understanding of how a decentralized economy
works to coordinate production activities with consumer preferences and
hence in our understanding of what might go wrong with the coordinating
mechanisms. The use of multiple stages of production gives full play to
marginalist thinking. Austrian macro is micro-friendly. The pattern of
resource allocation can be modified in systematic ways, changing the temporal
profile of production activities. A marginal decrease in late-stage activities
coupled by a marginal increase in early-stage activities has important
implications for the economy’s overall growth rate. Significantly, a
related pattern of marginal changes gives rise to boom and bust. Changes
in the intertemporal pattern of resource allocation have a claim on our
attention, according to the Austrians, even if these marginal changes cancel
one another out in some conventional macroeconomic aggregate such as investment
spending (in all stages) or total spending (by both consumers and the investment
community).
The pattern
of resource allocation associated with intertemporal equilibrium exhibits
a certain uniformity in terms of the value differentials that separate
the stages of production. The difference in the value of the output of
one stage and the value of output of the next stage reflects, among other
things, the general terms of intertemporal exchange, expressed summarily
as the market rate of interest. With a given rate of interest, excessive
stage-to-stage value differentials would present themselves as profit opportunities
which could be exploited only by reallocating resources toward the earlier
stages of production. In the limit, when all such profit opportunities
have been competed away, the relative prices of inputs used in the various
stages are brought into line with the equilibrium rate of interest. A summary
graphical rendering of the intertemporal capital structure takes the form
of a triangle encasing the sequence of stages that constitute such an intertemporal
equilibrium. The Hayekian triangle in Figure 9.1 keeps the many complexities
of capital theory at bay while keeping in play the overall time element
in the production process.
The extreme
level of simplification warrants some discussion. First, we note that the
triangle’s hypotenuse, which tracks the value of the yet-to-be completed
consumables, rises linearly from no value at all to the full market value
of the consumables. Yet, we know that the interest rate is expressed in
percentage terms and, starting from some initial input value, allows for
compounding. Clearly—and contrary to the Hayekian triangle—such percentage
value differentials implies that the cumulative value should be tracked
by a curve that rises exponentially from some initial value to some final
value. Here, linearity wins out on the grounds of its being simpler in
construction yet adequate to the task. It is also true to Hayek’s original
formulation. We need to recognize, however, that the triangle would be
inadequate for dealing with any issue for which the compounding effect
is critical. Ambiguities about the precise relationship between the interest
rate and the overall degree of roundaboutness arise when the effects of
compound interest are factored in. These and related ambiguities concerning
capital intensity lay at the heart of the Cambridge capital controversy
(Harcourt, 1972), a protracted and, ultimately, sterile debate that attracted
much attention a few decades ago. But for dealing with the business cycle
and related macroeconomic issues, the triangle, simple as it is, does just
fine.
Second, the
horizontal leg of the triangle, which invites us to imagine a sequence
of unit time intervals, does not translate readily into calendar time.
In application, an early stage of production consists only partly in goods
in process—pine saplings that mature over time into lumber or wine that
undergoes an aging process. Earliness is also implicit in durable capital
goods or even in human capital. These factors of production are categorized
as early-stage because they will have a yield over an extended future.
The heterogeneity of capital warns against trying to create a single metric,
such as some average period of production, or to quantify in some other
way the production time for the macroeconomy. Still, many early-stage activities
and late-stage activities are readily discernable. Inventory management
at retail is a late-stage activity. Product development is an early-stage
activity. Increases in the time dimension of the economy’s capital structure
might take the form of shifting resources from relatively late to relatively
early stages, of creating capital goods of greater durability, or of simply
changing the mix of goods produced in favor of those involving more time-consuming
(but higher yielding) production processes.
Third, the vertical
leg of the Hayekian triangle, which represents the value of consumable
output, implies that consumption occurs at a single point in time at the
end of the production process. This is not to deny the existence of consumer
durables. But expanding the intertemporal aspect of the macroeconomy to
include consumption time would complicate matters without adding much to
the analysis. The triangle focuses attention on the particulars of production
and on aspects of the market process that lose much of their relevance
once the goods are in the hands of the consumer. The notion of “stages
of consumption” would be contrived if not meaningless.
In application
there is a fine line—in Austrian theory as in more conventional theory—between
an investment good and a consumer durable. Residential housing, whether
or not owner occupied, is universally categorized as investment, the rental
value (actual or implicit) of its services qualifying as consumption. Owner-driven
automobiles, however, despite their considerable durability and implicit
lease value are categorized as consumption goods. Instances can be imagined
in which a consumable (e.g. a light truck purchased new for non-commercial
use) is later sold into an early stage of production (e.g. as a work truck).
But as a general rule, goods delivered into the hands of consumers stay
in the hands of consumers Attention to these and related matters may be
necessary in particular applications of the Austrian theory, but the theory
itself is based on the vision of a multi-stage production process that
yields a consumable output.
In its simplest
interpretation, Figure 9.1 represents a no-growth economy. Gross investment,
financed by saving, is just enough to offset capital depreciation. With
given tastes and technology, the macroeconomy settles into an intertemporal
equilibrium and produces consumption goods at an unchanging rate. More
typically, saving and gross investment exceed capital depreciation, allowing
the economy to grow at every margin. If we can assume for the moment an
unchanging rate of interest, the growth can be represented by a triangle
of increasing size, its general shape remaining the same.
The payoff to
Hayekian triangulation, however, comes from allowing for changes in the
triangle’s shape. More conventional macroeconomic constructions make
the implicit assumption of structural fixity or structural irrelevance.
In the Austrian theory, changes in saving behavior have implications for
the allocation of resources within the economy’s capital structure. In
turn, the changing shape of the triangle affects the time profile of consumable
output. The natural focus of the analysis is on intertemporal coordination
and possible causes of intertemporal discoordiantion.
9.3 Saving and Economic Growth
We tend to think of economies as experiencing some on-going rate of
growth. The growth rate will be positive, negative, or zero, depending
upon the relationship between saving and capital depreciation. In a stationary,
or no-growth, economy, saving finances just enough investment to offset
capital depreciation. Consumable output is constant over time, as depicted
in the first two periods in Figure 9.2.
If saving is
in excess of capital depreciation, the economy grows. The volume of consumable
output rises over time, as depicted in the last three periods of the Figure
9.2. The output of each of the stages of production increases as well.
The economy grows at every margin, allowing even for a continual increase
in the number of stages. During a period of secular growth, the Hayekian
triangle increases in size but not—or not necessarily—in shape.
An interesting
question, one whose answer serves as a prelude to the Austrian analysis
of business cycles, concerns the transition from no growth to a positive
rate of growth—or, for that matter, from some i nitial
growth rate to a higher growth rate. What must be true about the time profile
of consumable output during the transition? Let’s assume that there has
been no change in the state of technology or in the general availability
of resources. We assume, though, that people’s intertemporal preferences
change if favor of future consumption. If confronted with the simple choice
between no growth and growth, people would surely prefer the latter. The
choice, however, is never quite that simple. The memorable acronym introduced
by science-fiction writer Robert Heinlein (1966) applies. TANSTAAFL:
“There ain’t no such thing as a free lunch.” Modifying the acronym
to fit the application, we recognize that TANSTAFG.
Free growth is not available for the asking, either.
The relevant
trade-off is that between consumable output in the near future and consumable
output in the more remote future. Are people willing to forgo some current
and near-term consumption in order to enjoy increasing consumption over
an extended period? It is the forgoing of current and near-term consumption,
after all, that frees up the resources with which to expand the economy’s
productive capacity and make increasing future consumption possible. In
Figure 9.2 the hypothesized preference change occurs at the end of the
second period. In light of this change, the output of consumption goods
during the third period needs to be reduced. The freed-up resources can
be employed in earlier stages of production. So altered, the capital structure
will eventually begins yielding consumables at an increased rate, matching
the initial output level at the end of the sixth period (in this particular
example) and exceeding it in the subsequent periods.
The market economy,
in the judgment of the Austrians, is capable of tailoring intertemporal
production activities to match intertemporal consumption preferences. The
temporal pattern of consumable output shown in Figure 9.2 requires a capital
restructuring, as can be depicted by a change in the Hayekian triangle’s
shape. Figure 9.3 shows the general nature of the required change. The
no-growth periods 1 and 2, which predate the preference change, are depicted
by the triangle having a relatively short intertemporal capital structure.
Beginning with the preference change at the end of period 2, consumption
falls, reaching a minimum at the end of period 3. The freed-up resources
can be allocated to the early stages of production and to the creation
of still earlier stages, enhancing the ability of the economy to produce
consumable output in the future. The reduced near-term yield of consumable
output and the increased number of stages of production is depicted by
the triangle 3, the smallest of the reshaped triangles.
As goods in
process begin to move through the restructured sequence of stages, the
output of consumables begins to rise. And with saving now in excess of
capital depreciation, expansion continues in each of the stages of production.
The economy experiences a positive secular growth rate, as shown by the
triangles 4 through 8, triangle 6 having the same consumable output as
the initial no-growth triangle. Yet to be discussed are the market mechanisms
that actually bring about this capital restructuring. At the point, the
focus is on the correspondence between the intertemporal capital restructuring
shown in Figure 9.3 and the temporal pattern of consumable output shown
in Figure 9.2.
The attention
here to a one-time simple preference change resulting in a transition from
a no-growth economy to an economy experiencing a positive secular growth
rate finds justification in analytical and heuristic convenience. More
complex preference changes can easily be imagined. Actual changes in intertemporal
preferences may themselves be gradual, and the preferred time profile of
consumables is undoubtedly not as simply described as is the intertemporal
pattern in Figure 9.2. This in only to say that a decentralized economy—including
its intertemporal dimension—entails much more complexity than can be
depicted by our simple pedagogical constructions.
The key feature
of Figure 9.2 is the reduction of consumable output during the transition
from no growth to a positive rate of growth. The forgone consumption is
a manifestation of the Heinleinian principle: There ain’t no such thing
as free economic growth. In applications where the initial rate of growth
is positive, there need not be an actual decline in consumable output.
In this circumstance, the Heinleinian principle would manifest itself in
a more subtle way. With consumable output growing initially at a rate of,
say, 2%, an increased willingness to save may give rise to a pattern of
output that rises continuously but at changing rates—possibly from the
initial rate of 2% to 1% and then subsequently to 3%. During the transition
period, in which the growth rate is only 1%, people are forgoing consumable
output that they could have enjoyed had they not decided to increase their
saving.
The explicit
recognition of the opportunity costs associated with saving-induced growth
underlies a general proscription relevant to policymaking. In short, the
Austrians are not cheerleaders for growth. Many introductory and intermediate
texts introduce the subject matter of macroeconomics with a short list
of policy goals. Invariably, a prominent entry on the list is rapid economic
growth. But is there any basis for including a high growth rate as a goal
for policymakers to achieve? What is needed, according to the Austrians,
is institutional arrangements that allow the growth rate of consumable
output to be consistent with peoples willingness to save. Production plans
need to be consistent with consumption preferences. But that consistency
may entail a low growth rate, no growth, or—in unusual circumstances—even
a negative growth rate. The growth rate itself is nothing but a summary
description of people’s willingness to forgo consumption in the near
future in order to enjoy increased consumption in the more remote future.
Macroeconomists should not adopt “rapid growth” as one of their goals
any more than microeconomists should adopt “plenty of vegetables” as
one of theirs.
Still, there
are key macroeconomic issues in play here. Achieving the right growth rate
in macroeconomics has its parallel in microeconomics in achieving the right
quantity of vegetables. As discussed in the following two sections, both
of these goals are achieved if the relevant supply and demand schedules
accurately reflect the fundamentals—the preferences and constraints that
govern the respective market activities.
9.4 The Saving-Investment Nexus
Is there a market mechanism that allows people actually to make the
trade-offs discussed in the previous section? This is a critical question—one
that lies at the heart of macroeconomic debate and one whose answers separate
the different schools of thought. The question can be posed in a way that
highlights the macroeconomic concerns: Is there a market mechanism that
brings saving and investment in line with one another without at the same
time having perverse effects (e.g. widespread resource idleness) on the
macroeconomy? The alternative answers have clear implications about the
viability of market economies and about the proper role of the policymaker.
9.4.1 A detour through monetarism
Some macroeconomists would answer the critical question in the affirmative,
taking the market’s allocation of resources to the production of consumption
goods and the production of investment goods, the later financed by saving,
to be on a par with the market’s allocation of resources to the production
of fruits and the production of vegetables. In other words, within the
overall output aggregate, the allocation issue—whether among narrowly
defined goods (peaches and potatoes) or among broad-based sub-aggregates
(consumption and investment)—is largely the province of microeconomics.
Macroeconomics,
in this view, should focus on the overall output aggregate itself as it
relates to other macroeconomic variables, such as the general price level
and the money supply. These macroeconomic variables, symbolized as Q, P,
and M, come together in the familiar equation of exchange,
(9.1)
MV = PQ.
This equation, of course, was ground zero for the monetarist counterrevolution
against the Keynesianism of the 1950s. The velocity of money, V, is defined
by the equation itself, and prior to the 1980s its empirically demonstrated
near-constancy in different countries and in different time periods established
a strong relationship between the money supply and some index of output
prices. What is commonly known as the quantity theory of money is more
descriptively called the quantity-of-money theory of the price level.
The monetarists
argued that the long-run consequence of a change in the money supply is
an equi-proportional change in the general level of prices—a consequence
tempered only by ongoing secular changes in real output and in the velocity
of money. Allowances were made for short-run variations in real output.
That is, overall output Q may rise and then fall while P is adjusting to
an increased M. However, the monetarists paid little attention to the relative
movements of the major sub-aggregates (consumption and investment) during
the adjustment process and no attention at all to the sub-aggregates (stages
of production) that make up aggregate investment. Whether dealing with
long-run secular growth or with short-run money-induced movements in real
output, the focus was on the summary output variable Q. Whatever change
is occurring within the output aggregate—as might be tracked by
the Austrians in terms of the Hayekian triangle—were taken to be irrelevant
to the greater issues of macroeconomics.
9.4.2 The saving-cum-investment perversity of Keynesianism
It was Keynesian economics, of course, that the monetarist counterrevolution
was intended to counter. But on the issue of a saving-investment nexus,
the counter could be more accurately described as a cover-up. In his General
Theory Keynes (1936, p. 21) had explicitly faulted his predecessors
and contemporaries for “fallaciously supposing that there is a nexus
which unites decisions to abstain from present consumption with decisions
to provide for future consumption.” According to Keynes, there is no
simple and effective way of coordinating these two decisions. Rather, the
mechanisms that do eventually bring saving into line with investment are
indirect and perverse. The saving-cum-investment perversity, in
fact, is central to the Keynesian vision of the macroeconomy (see Leijonhufvud,
1968).
The equation
of exchange can be rewritten in a way that uncovers the issues on which
the Keynesian revolution was based. Aggregate output Q consists of the
output of consumption goods plus the output of investment goods. That is,
Q = QC + QI, the QI reckoned as the “final”
output of investment goods—so as to avoid double counting. The equation
of exchange, then, can be rewritten as
(9.2)
MV = P(QC + QI),
emphasizing that the problem as seen by Keynes (the volatility of QI
and its impact on all other macroeocnomic magnitudes) is a problem that
is simply not addressed by the monetarists. Rather, replacing the Keynesian
QC + QI with the monetarist Q served only to cover
up the primary locus of perversity. The question of just how the output
of investment goods gets squared with preferred trade-off between current
consumption and future consumption is not answered by the monetarists—nor
is it even asked.
In the Keynesian
vision, which will be dealt with at some length in Section 9.11, movements
in the investment aggregate impinge in the first instance on incomes, which
in turn impinge on consumption spending. That is, QC and QI
move in the same direction, the movements in QI being unpredictable
and the corresponding same-direction movements in QC being amplified
by the familiar Keynesian multiplier. Similarly, autonomous changes in
current consumption, if any, would tend to affect profit expectations and
hence cause investment spending to change in the same direction. Here,
the principle of derived demand is in play. With the two major sub-aggregates
moving up and down together (though at different rates), the Keynesian
theory precludes by construction any possibility of there being a trade-off
of the sort emphasized by the Austrians. Further, considerations of durable
capital and the so-called investment accelerator imply the absence of a
generally binding supply-side constraint. There is simply no scope in the
Keynesian vision for investment to rise at the expense of current
consumption. Similarly, market participants willing to forgo current consumption
(i.e., to save) in order to be able to enjoy greater future consumption
would find their efforts foiled by the market mechanisms that link saving
and investment. Rather than stimulating investment, increased saving would
impinge on overall spending and hence on overall income. This perverse
negative income effect, which Keynes identified as the paradox of thrift,
is discussed at length in Section 9.9.
9.4.3 Austrian disaggregation
The Austrian perspective on Keynesianism and monetarism in the context
of the equation of exchange is revealing. Keynesianism adopts a level of
aggregation that suggests a potential problem—one of dividing resources
appropriately between consumption and investment—but without allowing
for a non-perverse market solution to that problem. Monetarism, as well
as most strands of new classicism, increases the level of aggregation,
obscuring this central issue and hence relegating the problem as well as
its solution to the realm of microeconomics. Predating both monetarism
and Keynesianism, the Austrians were inclined to work at a lower level
of aggregation than either of these schools, one in which both the problem
and a potentially viable market solution could be identified.
Again, the equation
of exchange can serve as the common denominator of the different schools
of thought. For the Austrians, the investment aggregate in the Keynesian
rendition must be disaggregated so as to bring the stages of production
into play. QC is consumable output, or goods of the first order—to
use Menger’s terminology. Investments distributed across the nine preceding
stages are identified as Q2 through Q10. The equation
of exchange thus becomes:
(9.3)
MV = P(QC + Q2 + Q3 + Q4 +
Q5 + Q6 + Q7 + Q8 + Q9
+ Q10).
Just as QI is reckoned as “final” output in conventional
macroeconomic theorizing, the second and higher-order goods (Q2
through Q10) in Equation 3 are similarly reckoned so as to maintain
the integrity of the equation of exchange. Double counting is thus avoided,
and the sum of the output magnitudes (in Equations 2 and 3) is equal to
total output and, equivalently, to total income. But with the Austrian
disaggregation, the focus of the analysis is on the relative movements
among the Q’s as well as on their sum.
In the Keynesian
construction, it might well seem implausible that an increase in saving
and a corresponding decrease in spending on QC could cause QI
to increase. If business firms are having problems selling out of their
current inventories, they are unlikely to be inspired to commit additional
resources to an expanded capacity and hence to the further overstocking
of these inventories. The doctrine of derived demand suggests that the
demand for productive capacity will mirror the demand for output. In the
Austrian construction, the doctrine of derived demand is tempered by considerations
of time discount. The multiple stages of production allow for enough degrees
of freedom for the consequences of a fall in consumer spending to be described
in terms of a change in the
pattern of investment spending rather
than exclusively in terms of an opposing movement in an all-inclusive investment
aggregate. The story of how the market can plausibly work can be squared
with the doctrine of derived demand, but as told by the Austrians, the
story is not dominated by it. The analysis draws on microeconomics as well
as macroeconomics and, as indicated earlier, the main character is the
entrepreneur.
9.4.4 Derived demand and time discount
An increase in saving sends two market signals to the business
community. Both must come into play if a change in intertemporal preferences
is to get translated successfully into corresponding changes in the economy’s
multi-stage production process. Changes in output prices together with
changes in the interest rate have consequences that affect the various
stages of production differentially. A non-perverse reallocation of resources
in the face of increased saving hinges critically on two principles: the
principle of derived demand and the principle of time discount. It is worth
noting here that perceived perversities in the saving-cum-investment
nexus of market economies stem from an implicit denial of the second-mentioned
principle. If derived demand is taken to be the only principle in play,
then it follows almost trivially that the market cannot adapt to an increase
in saving.
Increased saving
means decreased current demand for consumer goods. (Of course, for a growing
economy in which both saving and consumption are increasing, we would have
to think in terms of changes in the relative rates of increase. More rapidly
increasing saving means a less rapidly increasing demand for consumer goods.)
A decrease in the demand for goods of the first order—again, Menger’s
terminology—has straightforward implications for the demand for goods
of the second order. The demand for coffee beans moves with the demand
for coffee. Menger’s Law prevails. More generally, the demand for inputs
that are in close temporal proximity to the consumable output moves with
the demand for that output. The demand for goods of the second order is
a derived demand. Under strict ceteris paribus conditions, which
would entail no change in the rate of interest, derived demand would be
the whole story.
The more favorable
credit conditions brought about by the increase in saving is the basis
for the rest of the story. A lower interest rate allows businesses to carry
inventories more cheaply. But how important is this change in supply conditions?
In gauging the relative changes in the demands for goods of the first order
and goods of the second order (coffee and coffee beans), the time-discount
effect is weak. Inventories of coffee beans are held for only a short period
of time, and consequently, the time discount effect—in this case, the
reduced costs of carrying inventory—is trivial compared to the derived-demand
effect. The demand for coffee beans falls almost as much as the
demand for coffee. The strength of the time discount effect is greater—and
increasingly greater—for the higher orders of goods. Consider, say, a
tenth-order good in the form of durable capital equipment. Testing facilities
and laboratory fixtures devoted to product development are good examples.
More favorable credit conditions could easily tip the scales toward creating
or expanding such a facility. In early stages of production, the time-discount
effect can more-than offset the derived-demand effect.
Considerations
of time discount draws resources into early stages of production. Further,
in gauging the profitability of early-stage activities, the derived-demand
effect itself can be augmenting rather than offsetting. Here, the entrepreneurial
element comes into play in a special way. What counts as the relevant derived
demand is not based on the current demand for goods of the first
order but rather on the anticipated demand at some future point in time—a
demand that may well be strengthened precisely because of the accumulation
of savings. The increased saving need not be taken as an indication that
the demand for consumables is permanently reduced. Rather, savers
are saving up for something. And entrepreneurs who best anticipate just
what they will be inclined to buy with their increased buying power stand
to profit from the intertemporal shift in spending.
The interplay
between derived demand and time discount accounts for the change in the
pattern of resource allocation brought about by an increase in saving.
A judgment might be made that this account saddles the entrepreneurs with
a greater burden than they can bear. Yet, those same entrepreneurial skills
were already in play in maintaining the intertemporal capital structure
before the increase in saving. That is, even
in the absence of a change in intertemporal preferences, market conditions
throughout the economy are continuously changing in every other respect—changes
in tastes, in technology, in resource availabilities. Entrepreneurs must
continuously adapt to those changes, while maintaining the temporal progression
from early-stage to late-stage activities. An increase in saving simply
requires that they make use of those same skills—but under marginally
changed credit conditions. A more plausible judgment would be that an economy
unable to adapt to a change in saving preferences is most likely unable
to maintain a tolerable degree of economic coordination even in the absence
of such changes.
Figure 9.4 reproduces
the equation of exchange with the investment sector disaggregated into
nine stages of production. The arrows indicate the direction and relative
magnitude of the change in the output quantities brought about by an increase
in saving. The reduction in the output of first-order goods (QC)
is echoed in the reduction in the output of second-through-fifth order
goods (Q2, Q3, Q4, and Q5),
the magnitude of the reduction attenuated by the time-discount effect for
the increasingly higher orders of goods. Starting (in this illustration)
with sixth-order goods, the time-discount more-than-offsets the derived-demand
effect. There are increases in the output levels of sixth and earlier stages
of production (Q6, Q7, Q8, Q9,
and Q10), the time-discount effect becoming more dominant with
increasingly higher order goods.
The increased
savings frees up resources, which are then allocated to the different stages
of production in a pattern governed by the more favorable credit conditions.
Grouping Q2 through Q10 together in Figure 9.4, we
see that overall investment rises as the current demand for consumable
output (QC) falls. Contrary to Keynes’s paradox of thrift,
consumption and investment can move in opposite directions. Attention to
the intertemporal pattern of investment allows us to resolve the paradox
and to show how changes in investment can be consistent with changes in
saving behavior. The wholesale neglect of the pattern of investment underlay
an early judgment by Hayek (1931) that “Mr. Keynes’s aggregates conceal
the most fundamental mechanisms of change.” It is significant that those
fundamental mechanisms are set into motion by the supply and demand for
loanable funds—because it was loanable-funds theory, a staple in the
pre-Keynesians’ toolkit, that Keynes specifically jettisoned.
9.5 The Market for Loanable Funds
Loanable-funds theory has an honorable history. Over the years and across
several schools of thought, theorizing abstractly in terms of “loans”
was simply a way of recognizing that the mechanisms of supply and demand
govern the intertemporal allocation of resources. The macroeconomic implications
of loanable-funds theory are best seen by focusing on the resources themselves
rather than on any particular financial instrument that allows the allocator—the
entrepreneur—to take command of the resources.
People produce
output in a wide variety of forms. With their incomes they engage in consumption
spending, laying claim to most-but-not-all of the output that they have
collectively produced. The part of income not so spent, that is, their
saving, bears a strong and systematic relationship to the part of the output
that is not currently consumed. These unconsumed resources can be made
available for increasing the economy’s productive capacity. In a market
economy, there are a number of different financial instruments (bank deposits,
passbook accounts, bonds, and equity shares) that transfer command over
the unconsumed resources to the business community.
The term “loanable
funds,” then, refers summarily to all the ways that the investment community
takes command of the unconsumed resources. Further,
taking command
has to include retaining command—in the case of the undistributed
earnings of the business community. Here, the business firm, in order to
expand its own productive capacity, is forgoing some market rate of return
on its retained earnings, a rate that it could have obtained through the
financial sector. For macroeconomic relevance, however, loanable funds
exclude consumer loans. Income earned by one individual and spent on consumption
either by that individual or—through saving and the consumer-loan market—by
another individual is not the focus of loanable-funds theorizing.
With loanable
funds broadly defined to capture the variety of ways that real investments
can be financed, the corresponding interest rate that equilibrates this
market must be understood in terms that are similarly broad. A full-bodied
theory of finance would have to allow for many interest rates, the variations
among them being attributable to differences in risk, liquidity, and time
to maturity. But for getting at the fundamental relationships among the
variables of capital-based macroeconomics (output, consumption, saving,
investment, and even the intertemporal pattern of resource allocation),
a summary rate is adequate. As will be noted in subsequent sections, some
considerations that account for a variation among different interest rates
may exacerbate the effects of a change in the summary rate, while other
considerations may ameliorate those effects. But in any case, the fundamental
differences that separate capital-based macroeconomics from other schools
of macroeconomics do not hinge in any important or first-order way on relative
movements of different rates of return within the financial sector.
Figure 9.5 represents
the simple analytics of the loanable-funds market. The supply of loanable
funds is, for the most part, saving out of current income. In real terms,
it is that part of current output not consumed. The demand for loanable
funds reflects the eagerness of the business community to use that saving
to take command of the unconsumed resources. These two macroeconomically
relevant magnitudes of saving and investment are not definitionally the
same thing but rather are brought into balance by equilibrating movements
in the broadly conceived rate of interest.
To feature the
supply and demand for loanable funds in this way is only to suggest that
in a market economy the interest rate is the fundamental mechanism through
which intertemporal coordination is achieved. Simply put, the interest
rate allocates resources over time. There need be no claim here that this
Marshallian mechanism works as cleanly and as swiftly as the supply and
demand for fish at Billingsgate. Because of the elements of time and uncertainty
inherent in the intertemporal dimension of loanable-funds market, the interest-rate
signal can be subject to interpretation.
What if some
income is neither spent on consumption nor offered as funds for lending?
That is, what if people—unexpectedly and on an economywide basis—prefer
to add to their cash holdings? The increased
demand for cash holdings would constitute saving in the sense of income
not consumed but would not constitute saving in the sense of an increase
in the supply of loanable funds. One important consequence of the Keynesian
revolution was to elevate considerations of liquidity preferences to the
point of dwarfing considerations of intertemporal preferences. The rate
of interest was thought to be dominated by changes in the demand for money.
Even in the counterrevolutionary contributions of the monetarists, the
interest rate was featured on the left-hand side of the equation of exchange—as
a parameter that affects the demand for money—and not on the right-hand
side as a key allocating mechanism working within the output aggregate.
(It is precisely because of this left-handedness of its treatment of the
interest rate that Milton Friedman’s restatement of the quantity theory
is taken by some scholars as a contribution in the Keynesian tradition;
see Garrison, 1992.)
The attention
to the loanable-funds market as depicted in Figure 9.5 reflects the judgment
of the Austrians that the rate of interest, though hidden from view in
the monetarists’ equation of exchange, is quintessentially a key right-hand-side
variable. The interest rate’s primary role in a market economy is that
of allocating investable resources in accordance with saving behavior.
There is no denying that the interest rate can, on occasion, play a role
on the left-hand-side of the equation of exchange—as a minor determinant
of money demand or as a short-run consequence of hoarding behavior. Still,
these monetarist and Keynesian concerns are subordinate ones in the Austrians’
judgment. An exogenous change in money demand is rarely if ever the source
of a macroeconomic disruption. (Here, the Austrians fall in with the monetarists.)
And an occasional dramatic change in liquidity preference is more likely
to be a consequence of an economywide intertemporal coordination
failure than a cause of it. (Here, even Keynes agreed that in the
context of business cycles the scramble for liquidity is a secondary phenomenon.
His concern about the “fetish of liquidity,” a wholly unfounded concern
in the Austrians’ view, was spelled out in the context of long-term secular
unemployment.)
Figure 9.5 (the
loanable-funds market) and Figure 9.1 (the Hayekian triangle) tell the
same story but at two different levels of aggregation. Figure 9.5 shows
how
much of the economy’s resources are available for investment purposes.
Figure 9.1 shows just how those resources are allocated throughout
the sequence of stages. A change in the interest rate, say, a reduction
brought about by an increase in saving, has systematic consequences that
can be depicted in both figures. The interest rate governs both the amount
of investable resources and the general pattern of allocation of those
resources. A rightward shift in the supply of loanable funds would move
the market along its demand curve, reducing the interest rate to reflect
the increased availability of investable resources. At the same time, that
reduced rate on interest would give a competitive edge to early-stage investment
activities. Resources available for the expansion of long-term projects
come in part form the overall increase in unconsumed resources and in part
from a transfer of resources from late-stage activities, where lower investment
demand reflects the lower demand for current and near-term output.
The effects
of increased saving at both levels of aggregation are explicit in Figure
9.4 and implicit in Figure 9.5. The change in the pattern of resource allocation
is depicted as the systematic changes in the direction and magnitude of
the stage-by-stage output levels. The increase in unconsumed resources
is depicted by the reduction in the output of goods of the first order
and in the corresponding increase in the output of second-through-tenth-order
goods. And all this is implied by a rightward shift in the supply of loanable
funds: More unconsumed resources are being allocated on the basis of lower
interest rate.
What is missing
in the discussion at this point is any explicit recognition of an overall
resource constraint. Scarcity is implicit in the notion that, for a given
period, output magnitudes as depicted in Figures 9.3 and 9.4 move differentially,
with some increasing and others decreasing. Early-stage activities are
expanded at the expense of current consumption and late-stage activities.
The overall resource constraint can be made explicit by the introduction
of a production possibilities frontier that makes the two-way distinction
between current consumption, which is already depicted as the vertical
leg of the Hayekian triangle, and investment, which is already being tracked
along the horizontal axis of the loanable-funds diagram. A fully employed
economy can be represented as an economy producing on its production possibilities
frontier.
9.6 Full Employment and the Production Possibilities Frontier
The existence of an overall resource constraint is inherent in the concept
of full employment. A fully employed economy is one in which the supply-side
constraints are binding. The full employment of labor and other factors
of production gets us full-employment output and full-employment income.
This much is accepted by all schools of macroeconomic thought. But what
constitutes unemployment in the macroeconomically relevant sense? And what
can we make of the conventionally defined categories of frictional, structural,
and cycle components of unemployment? These are the issues that separate
the Austrians from other schools.
For Keynes,
unemployment was to be gauged with reference to some “going wage,”
which itself came into being during a period when the economy was suffering
from no macroeconomic maladies. In subsequent periods the economy’s actual
state of macroeconomic health is determined, in the Keynesian way of thinking,
by comparing the quantity of labor demanded at the going wage with the
quantity of labor offered in supply. If these two quantities (demanded
and supplied) are the same, then labor (along with all other resources)
is fully employed. If, under less favorable market conditions, the quantity
demanded is deficient relative to of the quantity offered in supply at
the previously established going wage, the discrepancy stands as a measure
of cyclical unemployment.
Central to this
Keynesian reckoning was the idea that the going wage kept going even after
the market conditions that underlay it were gone. It was in this context
that Keynes (1936, p. 15) used the term “involuntary unemployment,”
the involuntariness deriving from the idea that the workers have fallen
victim to the institutions of capitalism—institutions that do not allow
for some uniform adjustment in the overall level of wages. Involuntary
unemployment is used here to mean cyclical unemployment. Here, we should
acknowledge Keynes’s belief, not shared by modern Keynesians, that ongoing
secular unemployment of the involuntary variety is inherent in the nature
of the market system.
Both Keynes
and modern Keynesians allow for some unemployment even in the absence of
involuntary, unemployment, that is, even when the economy is not in recession.
In a healthy economy, the unemployed consist of new entrants into the labor
force who haven’t yet accepted a job offer as well as members of the
labor force who are between jobs. Modern textbooks commonly make the distinction
between frictional unemployment, meaning simply that in a market economy
job applicants and job openings are not matched up infinitely fast, and
structural unemployment, meaning that there are significant mismatches
between applicants and openings, such as to require costly retraining and/or
relocation.
Though the difference
between frictional and structural unemployment is a substantive one, the
ultimate purpose of this unemployment taxonomy is to make a sharp distinction
between these components of unemployment and the remaining component, which
alone is a measure of the economy’s departure from its overall, macroeconomically
relevant supply-side constraints. As a rule of thumb, the frictional-cum-structural
unemployment may be five-to-six percent of the labor force. Hence, a measured
unemployment in a market economy of, say, eight percent would suggest that
the economy is in recession and that the cyclical component of the measured
unemployment, that is, the unemployment attributable to recessionary conditions,
is two-to-three percent.
This well-known
taxonomy of unemployment (frictional, structural, and cyclical) is spelled
out here to facilitate an important contrast between the Austrians’ reckoning
of unemployment and this more conventional reckoning. Capital-based macroeconomics
features the intertemporal structure of production. And as will
be seen in Section 9.10 below, business cycles entail a distortion of the
structure, a misallocation of labor and other resources among the stages
of production. Hence, cyclical unemployment—or, at least, an essential
part of it—is a special case of structural unemployment. The Austrians
depart from convention, then, in their judgment that structural unemployment
and cyclical unemployment are not mutually exclusive categories.
A second feature
of the Austrian’s reckoning of employment levels—and of resource constraints
generally—is illuminated by considering the monetarists’ notion of
the natural rate of unemployment. Rather than emphasize the different categories
of unemployment as discussed above, the monetarists make the two-way distinction
between the rate of unemployment that would "naturally" exist even in a
healthy market economy and rates of unemployment that are in excess of
this natural rate. (Milton Friedman coined the term "natural rate of unemployment"
to emphasize its kinship with the “natural rate of interest,” a similarly
defined term introduced by Swedish economist Knut Wicksell, see Leijonhufvud,
1981.) The difference here between the monetarists and the Keynesians is
terminological rather than substantive. The natural rate of unemployment
is in the range of five-to-six percent. And an economy that is experiencing
the natural rate of unemployment is said to be fully employed.
Consistent with
this reckoning, an economy experiencing the natural rate of unemployment
can be said to be on its production possibility frontier. The frontier,
then, can allow for deviations in either direction. That is, an economy
in recession would be represented by a point inside its frontier, and an
overheated economy, one in which the unemployment rate has been pushed
temporarily below the natural rate, would be represented by a point beyond
its frontier. This is only to say that the frontier itself is defined in
terms of sustainable levels of output and not in terms of some short-run
maximal level of output.
Figure 9.6 depicts
a wholly private economy’s production possibilities frontier in terms
of sustainable combinations of consumable output and investment. This economy
is experiencing full employment, its unemployment rate being no more than
five-to-six percent. The vertical axis keeps track of consumables in a
way that conforms to final-stage output as represented by the vertical
leg of the Hayekian triangle. The horizontal axis keeps track of gross
investment. Hence, if capital depreciation just happened to be equal to
the gross investment, the economy would be experiencing no economic growth.
Typically, depreciation will be something less than gross investment, and
the economy will enjoy a positive growth rate, the frontier itself expanding
outward from period to period. In the unlikely case in which gross investment
falls short of depreciation, of course, the economy would be in economic
decline, the frontier shifting inward from period to period.
As one of its
critical features, capital-based macroeconomics allows for movements
along
the frontier in one direction or the other in response to changes in intertemporal
preferences. A clockwise movement would represent the sacrifice of current
consumption in favor of additional investment. The initial reduction of
consumable output would eventually be offset and then more-than-offset
as the frontier itself shifts outward at an accelerated rate. The time
path of consumable output would be that depicted in Figure 9.2. A counterclockwise
movement would represent a sacrifice in the opposite direction. The initial
increase in consumable output would carry the cost of a decrease in the
economy’s growth rate and possibly even a negative growth rate.
Significantly,
these possible clockwise and counterclockwise movements are the sort of
movements precluded by construction in Keynesian theorizing, as will be
shown in Sections 9.9 and 9.11, and ignored in monetarist theorizing, owing
to the level of aggregation that characterizes the equation of exchange.
A major focus of Austrian theorizing is on the market mechanisms that allow
for such movements—and on policy actions that lead to a disruption of
these mechanisms. The macroeconomic health entails more than an unemployment
rate that stays within the range of five-to-six percent. It also entails
a growth rate that is consistent with intertemporal preferences.
Three distinct
but mutually reinforcing perspectives on the key relationships of capital-based
macroeconomics are provided by the production possibilities frontier, the
loanable-funds market, and the Hayekian triangle. In the following section,
these three graphical components, which come together to create a capital-based
macroeconomic framework, provide a firm basis for the Austrian propositions
about saving and growth and for the Austrian theory of the business cycle.
9.7 The Capital-Based Macroeconomic Framework
The three components discussed above are assembled in Figure 9.7 to
depict an intertemporal equilibrium in a fully employed macroeconomy. Full
employment is indicated by the locus of this economy on its production
possibilities frontier. The particular location on the frontier is determined
by the loanable-funds market, in which the rate of interest reflects the
saving preferences of market participants. The corresponding consumption
preferences are accommodated by the output of the final stage of production
in the Hayekian triangle. Resources are being allocated among the stages
of production on the basis of the cost of investment funds, such that the
rate of return in the real sector, as reflected in the slope of the triangle’s
hypotenuse, corresponds to the rate of return in the financial sector,
as depicted by the market-clearing interest rate in the loanable-funds
market. Figure 9.7 and subsequent figures are adapted from Garrison (2001).
For an economy
in a macroeconomic equilibrium as just described, the rates of return (in
both the real and the financial sectors) can be summarily described as
“the natural rate of interest.” Parametric changes, such as a change
in saving preferences, can change the natural rate. For instance, increased
saving preferences will cause the market-clearing rate of interest to be
lower and the slope of the triangle’s hypotenuse to be a shallower
one. The capital-based macroeconomic framework is designed to show (1)
how market forces establish a new natural rate in response to some parametric
change and (2) how the economy reacts to policies aimed at maintaining
an interest rate in the financial sector that is inconsistent with—typically
below—the natural rate. Uses of these analytics to deal with other macroeconomic
issues, such as deficit finance and tax reform, are demonstrated in Garrison
(2001); some extensions of Austrian business cycle theory are suggested
by Cochran (2001).
In its simplest
interpretation, Figure 9.7 depicts a steady-state, no-growth economy. There
is no net investment. The positive level of saving and investment
shown in the loanable-funds market is just enough to offset capital depreciation.
As capital goods wear out and are replaced, the Hayekian triangle is maintained
from period to period in terms of both size and shape. This is the circumstance
that corresponds to the first two periods of Figure 9.2. If, as is ordinarily
the case, investment exceeds capital depreciation, the economy experiences
secular growth in all its dimensions. The production possibilities frontier
shifts outward,
both the supply and demand for loanable funds shift rightward, and the
Hayekian triangle changes in size but not—or, at least, not necessarily—in
shape. This is the circumstance that corresponds to the last several periods
of Figure 9.2. It should be noted that secular growth in which there is
no change in the shape of the Hayekian triangle presupposes that the supply
of loanable funds and the demand for loanable funds shift rightward to
the very same extent, such that there is no change in the rate of interest.
Ordinarily, we would think of the increased income and wealth that economic
growth makes possible as being accompanied by an expanding time horizon
and hence by an increased inclination to save. Factoring in increased saving
preferences would allow for a reduction in the rate of interest and a change
in the shape as well as of the size of the Hayekian triangle.
9.8 Saving-Induced Capital Restructuring
Suppose that in circumstances of a no-growth economy and a natural rate
of interest of ieq, people become more thrifty. The increased
saving is depicted in Figure 9.8 as a rightward shift in the supply of
loanable funds (from S to S’). With the resulting downward pressure on
the interest rate, the loanable-funds market is brought back into equilibrium.
The natural rage of interest falls from ieq to i'eq.
The reduced cost of borrowing motivates the business community to expand
investment activities. Increased saving, of course, means decreased
consumption. But the decreased consumption is offset by the increased investment,
allowing the economy to stay on its production possibility frontier. The
clockwise movement along the frontier in the direction of increased investment
is consistent with the hypothesized change in intertemporal preferences.
The corresponding
changes in the Hayekian triangle follow straightforwardly. The currently
reduced demand for consumable output (which depresses investment)
is accompanied by reduced borrowing costs (which stimulate investment).
The effects of these changes in market conditions were discussed in Section
9.4.4 above in terms of “derived demand” and “time discount.” The
derived-demand effect dominates in the late
stages; the time-discount effect dominates in the early stages. Input prices
are bid down in the late stages (reflecting the low demand for current
and near-term output) and are bid up in the early stages (reflecting the
low borrowing costs). The changes in relative prices draw resources out
of the late stages and into the early stages. Further, stages of production
temporally more remote from final consumption than had existed before will
have yields that are attractive in the light of the low borrowing costs.
In the absence of any further changes in saving preferences or in any other
data, the new intertemporal equilibrium will entail a rate of return in
the real sector (consisting of all the stages) that matches the low rate
of interest in the financial sector. The general pattern of resource reallocation
is depicted as a shallower slope of the triangle’s hypotenuse.
In discussing
in more concrete terms the nature of these saving-induced reallocations,
the relevant distinction is not between labor and capital but rather between
resources of both kinds that are (relatively) nonspecific and resources
of both kinds that are (relatively) specific. Nonspecific capital, such
as building materials that can be used for building either retail outlets
or research facilities; will move out of comparatively late stages and
into early ones in response to relatively small price differentials. Specific
capital, such as mining equipment or amusement park attractions, may enjoy
a capital gain (in the first instance) or suffer a capital loss (in the
second). Similarly, nonspecific labor will migrate in the direction of
the early stages in response to small wage-rate differentials, while workers
who are wedded to particular stages may experience increased—or decreased—wage
rates. Note that the focus on the allocation of resources among the stages
of production in response to changes in relative prices and wages warns
against theorizing in terms of the wage rate.
Once the capital
restructuring is complete and the earliest saving-induced investments work
their way through the stages of production, the output of consumables will
increase, eventually exceeding the output that characterized the initial
no-growth economy. If we understand the saving that gave rise to the capital
restructuring not as a permanent reduction in consumption but rather as
an increased demand for future consumption, then we see that the reallocations
are consistent with the preference change that gave rise to them. Further,
we see that the clockwise movement along the production possibilities frontier,
followed by an outward expansion of the frontier itself traces out a temporal
pattern of consumption that is wholly consistent with the pattern depicted
in Figure 9.2. By forgoing consumption in the near term, people’s saving
behavior allows the economy to make the transition from a no-growth economy
to an economy experiencing secular growth.
Two qualifications
will help to put in perspective this account of the market’s reaction
to an increase in saving. First, the assumption of an initial no-growth
economy was made purely for pedagogical reasons. In this setting the changes
brought about by an increase in saving are isolated from any other ongoing
changes, such as those associated with secular growth. The demand for inputs
falls in some stages and rises in others. Some stages lose resources; others
gain them. In application, however, where there is already ongoing secular
growth, these same relative effects are expressed not in terms of absolute
decreases and increases but rather in terms of increases at a relatively
slow rate and increases at a relative rapid rate. The market is simply
doing the same things it did before the increase in saving—except for
its doing them under conditions of moderated consumption demand marginally
more favorable credit conditions. As suggested earlier, the plausibility
of the market being able to accommodate itself to the increase in saving
is about the same as the plausibility it could function reasonably well
during the period of secular growth.
Second, and
relatedly, the substantial one-time shift in the supply of loanable funds
shown in Figure 9.8 is not intended to suggest that saving behavior sometimes
changes that dramatically. Like adopting the assumption of no-growth, hypothesizing
a dramatic change serves a purely pedagogical purpose. In teaching the
basics of supply and demand, professors draw a substantially shifted curve
on the blackboard so that students in the back row can see it. There is
no implication here that actual changes in saving preferences tend to be
dramatic ones or that saving is in some sense unstable. Quite to the contrary,
in light of the complexities of the capital structure and the nature of
the market mechanisms that keep it in line with saving preferences, the
message should be that even small and gradual changes in saving preference
need to be accommodated by the appropriate movements of resources among
the stages of production. As in microeconomics, Austrian macroeconomics
is about marginal adjustments to parametric changes.
Because of the
explicit temporal element in the capital structure any inter-stage misallocations
can be cumulative. The avoidance of such misallocations requires the interest
rate to tell the truth about intertemporal preferences. The consequences
of a falsified interest rate (cumulative intertemporal misallocations followed
by a crisis) are the subject of Section 9.10 But it the following section
we consider the Keynesian view of increased saving in the context of our
capital-based macroeconomic framework.
9.9 Keynes’s Paradox of Thrift Revisited
It is instructive to compare the Austrians’ treatment of increased
saving and consequent market adjustments with Keynes's treatment of these
issues. There are two important differences. First, pre-empting any extended
analysis of changes in saving preferences was Keynes’s judgment that
such changes are unlikely to occur. Second, any increase in thriftiness,
should such a preference change actually occur, would in his reckoning
have perverse consequences for the economy.
Saving, in Keynes’s
theory, is a residual. It’s what’s left over after people do their
consumption spending, which itself is dependent only (or predominantly)
upon incomes. In the Keynesian framework, the rate of interest has no effect
(or only a negligible effect) on saving behavior. Hence, an extended analysis
of a
change in saving preferences was largely uncalled for. Keynes’s analysis
of the interest rate is carried out in terms of the supply and demand for
money (i.e., cash balances) and not in terms of the supply and demand for
loanable funds. And to the extent that Keynes did deal with loanable funds—or,
more pointedly, investment funds—his focus was on the other side of the
loanable-funds market. The demand for investment funds, in his view, is
subject to dramatic shifts owing to the uncertainties that are inherent
in investment decisions. A comparison of Keynesian and Austrian theories
of the business cycles, the Keynesian theory featuring a collapse in investment
demand, will be the subject of Section 9.11
Keynes’s judgment
that saving behavior is not subject to change was accompanied by some degree
of relief that this was the case. He argued that an increase in saving
would send the economy into recession. This is Keynes’s celebrated “paradox
of thrift.” If people try to save more out of a given income, they will
find themselves saving no more than before but saving that unchanged amount
out of a reduced income. That is, in their effort to increase their saving
rate, S/Y, by increasing the numerator of that ratio, they set a market
process in motion that increases the saving rate by decreasing the ratio’s
denominator. What is the essence of this market process that produces results
so different from those envisioned by the Austrians? In summary terms,
the Austrian story about derived demand and time discount becomes, in Keynesian
translation, a story about derived demand alone.
The market adjustments
envisioned by Keynes can be revealingly depicted as an alternative sequence
to the one shown in Figure 9.8. In Figure 9.9 the same initial conditions
of full employment are assumed. But in the spirit of Keynes, the loanable-funds
market is drawn with relatively inelastic saving and investment schedules.
The initial saving schedule is labeled S(Y0) to indicate that
people are saving out of an initial level of income of Y0. As
in the Austrian story, we show an increase in thriftiness by a rightward
shift of the supply of loanable funds—from S(Y0) to S'(Y0).
And as before, there is downward pressure on the interest rate. But in
the Keynesian story, the market process that might otherwise restore an
equilibrium relationship between saving and investment is cut short by
a dominating income effect. More saving means less consumption spending.
And less consumption spending means lower incomes for those who sell these
consumer goods. It also means reduced demand for the inputs with which
to produce the consumables, i.e., a reduced demand in factor markets, generally.
The economy
spirals downward as spending and incomes fall in multiple rounds. With
reduced incomes, saving is also reduced. As the process plays itself out,
the saving schedule shifts leftward from to S’(Y0) to S’(Y1),
where Y1<Y0. The negative income effect fully
offsets the positive increased-thrift effect. Both saving and investment
are the same as before the preference change. But with reduced consumer
spending and no change—and certainly no increase—in investment spending,
the economy has fallen inside the production possibilities frontier. (In
Figure 9.9 the upward-sloping line that intersects the frontier suggests
that the level of consumption in the thrift-depressed economy is lower
than it would have been had intertemporal coordination somehow been achieved
without the lapse from full employment. The parameters of this upward-sloping
"demand constraint" will be identified in Section 9.11.)
The Hayekian
triangle changes in size but not in shape. Note that even if Keynes were
to allow for the allocation of resources within the capital structure to
be achieved by changes in the interest rate, no thrift-induced reallocation
would take place—since (abstracting from possible changes in liquidity
preferences, which would only compound the perversities) the interest rate
does not change.
To isolate the
consequences of increased thriftiness, it is assumed that investment spending
does not change at all. But, of course, if the recessionary conditions
dampen profit expectations in the business community, investment spending
will actually fall, exacerbating the problems caused by the increased thriftiness.
The paradoxical—and
perverse—consequences of an increase in thriftiness are seen by Keynes
as the unavoidable outcome of the market process. In his own words, “Every
such attempt to save more by reducing consumption will so affect incomes
that the attempt necessarily defeats itself” (Keynes, 1936, p. 84). The
economy simply cannot move along its production possibilities frontier,
and savers who push in that direction will cause the economy to sink into
recession. Keynes paradox of thrift stands as a summary denial that a market
economy has the capability of achieving and maintaining an intertemporal
equilibrium in the face of changing saving preferences. Relative change
in resource allocations within the capital structure are no part of the
story. Again, the wholesale neglect of all such structural changes is what
Hayek (1931) had in mind when he remarked that “Mr. Keynes’s aggregates
conceal the most fundamental mechanisms of change.”
9.10 The Austrian Theory of the Business Cycle
The previous two sections provide a stark contrast between Austrian
and Keynesian views. They show how an increase in saving can move the economy
along its production possibilities frontier, allowing for an increase in
the economy’s rate of economic growth (the Austrian view), and how an
increase in saving necessarily throws the economy off its frontier and
into recession (the Keynesian view). Simply put, markets work in one view
and don’t work in the other.
For the Austrians,
the idea that markets work is not axiomatic. There is no claim that markets
are always guided only by the underlying economic realities—no
matter what institutional arrangements are in place and no matter what
macroeconomic policies are pursued. In fact, the Austrian theory of the
business cycle is a theory about a policy-induced departure—first in
one direction and then in the other—from the economy’s production possibilities
frontier.
For Keynes,
increased saving leads to recession. This proposition, however, did not
transform his paradox of thrift into an excess-saving theory of recessions.
As already indicated, Keynes believed that saving preferences were not
likely to change. The recession-inducing changes, in his view, were almost
always spontaneous changes on the demand side of the loanable-funds
market.
Keynes and Hayek
were critical of one another’s efforts to explain recessions, but their
assessments of one another’s books generated more heat than light and
failed to produce a head-to-head comparison of the contrasting views. Despite
all the interpreting, reinterpreting, and reconstructing of Keynesian ideas
over the last three-quarters of a century, it is instructive to compare
(in this and the following sections) the Austrian and (original) Keynesian
views on the nature and causes of business cycles.
According to
the Austrians, the market is capable of allocating resources in conformity
with intertemporal preferences on the basis of a market-determined (natural)
rate of interest. It follows, then, almost as a corollary that an interest
rate substantially influenced by extra-market forces will lead to an intertemporal
misallocation
of resources. This latter proposition is the essence of the Austrian theory
of business cycles. The cyclical quality of the departures from the economy’s
production possibilities frontier derives from the self-correcting properties
of a market economy. Misallocations are followed by reallocations. Note
that the market is not judged to be so efficient as to prevent from the
outset all policy-induced misallocations. As Hayek (1945) has taught us,
it cannot allocate resources in accordance with the “real factors”
(consumer preferences, technological possibilities, and resource availabilities)
except on the basis of information conveyed by market signals, including
importantly the rate of interest. It is movements in the interest rate,
along with the corresponding movements in input prices and output prices
that give clues to the business community about what those real factors
are and about how they may have changed.
The Austrian
theory of the business cycle is a theory of boom and bust with special
attention to the extra-market forces that initiate the boom and the market's
own self-correcting forces that turn boom into bust. We have already seen
that increased saving lowers the rate of interest and gives rise to a genuine
boom, one in which no self-correction is called for. The economy simply
grows at a more rapid rate. By contrast, a falsified interest rate that
mimics the loan-market conditions of a genuine boom but is not accompanied
by the requisite savings gives rise to an artificial boom, one whose artificiality
is eventually revealed by the market's reaction to excessively future-oriented
production activities in conditions of insufficient saving.
As with the
graphical depiction of saving and growth, the analytics of boom and bust
is begun with an assumed no-growth economy in an intertemporal equilibrium.
The initial (market-determined) rate of interest (ieq in Figure
9.10) also qualifies as the natural rate of interest. An artificial boom
is initiated by the injection of new money through credit markets. The
central bank adopts an interest-rate target below the rate of interest
that otherwise would have prevailed. Its operational target rate, of course,
is much more narrowly defined than the broadly conceived market rates shown
in the diagram. The central bank achieves its interest-rate target by augmenting
the supply of loanable funds with newly created credit. The Federal Reserve's
Open Market Committee buys securities in sufficient volume so as to drive
the federal funds rate down to the chosen target. With this action, market
rates generally are brought down to a similar extent—although, of course,
some more so than others. The fact that long-term rates tend not to fall
as much as short-term rates may mitigate—but cannot eliminate—the general
effects of the credit expansion. Further, these general effects are independent
of which particular policy tool the Federal Reserve employs. Credit expansions
brought about by a reduction in the discount rate (now called the primary
credit rate) or by a reduction in reserve requirements could be similarly
described. All of the institutionally distinct monetary tools are macroeconomically
equivalent: They are all means of lending money into existence and hence
have their initial effect on interest rates.
For comparison,
the central bank's augmentation of credit depicted in Figure 9.10 is set
to match the actual shift in the supply of saving depicted in Figure 9.8.
Rather than create a new equilibrium interest rate and a corresponding
equality of saving and investment as was the case in a saving-induced expansion,
the credit expansion creates a double disequilibrium at a sub-natural interest
rate. Savers save less, while borrowers borrow more. Note that if this
low interest rate were created by the imposition of an interest-rate ceiling,
the situation would be different. With a legislated ceiling, borrowing
would be saving-constrained. The horizontal distance at the ceiling rate
between supply and demand would represent a frustrated demand for credit.
A credit shortage would be immediately apparent and would persist as long
as the credit ceiling was enforced.
Credit expansion
papers over the credit shortage that would otherwise exist. The horizontal
distance between supply (of saving) and demand (for credit) is not frustrated
demand but rather demand accommodated by the central bank’s injections
of new credit. It represents borrowing—and hence investment—that is
not
accommodated by genuine saving. In the final analysis, of course, real
investment cannot be in excess of real unconsumed output. To say that credit
expansion papers over the shortage is not to say that it eliminates the
problem of a discrepancy between saving and investment. It only conceals
the problem—and conceals it only temporarily. In summary terms we see
that padding the supply of loanable funds with newly created money drives
a wedge between saving and investment. The immediate effect of this padding
is (1) no credit shortage, (2) an economic boom in which the (concealed)
problem inherent is a mismatch between saving and investment festers, and
(3) a bust, which is the eventual but inevitable resolution to the problem.
(With this summary reckoning, however, we have gotten ahead of the story.)
The double disequilibrium
in the loanable-funds market has as its counterpart the two limiting points
on the production possibilities frontier. Saving less means consuming more.
But with a falsified interest rate, consumers and investors are engaged
in a tug-of-war. If, given the low rate or return on savings, the choices
of consumers were to carry the day, the economy would move counterclockwise
along the frontier to the consumers’ limiting point. Similarly, if, with
artificially cheap credit, the decisions of investors were to carry the
day, the economy would move clockwise along the frontier to the investors’
limiting point. Of course, neither set of participants in this tug-of-war
is wholly victorious. But both consumer choices and investment decisions
have their separate—and conflicting—real consequences. Graphically,
the participants are pulling at right angles to one another—the consumers
pulling upward in the direction of more consumption, the investors pulling
rightward in the direction of more investment. Their combined effect is
a movement of the economy beyond the frontier in the direction of a “virtual”
disequilibrium point that is defined by the two limiting points.
Having defined
the production possibilities frontier in terms of sustainable levels of
output, we can allow for the economy to move beyond the frontier—but
only on a temporary basis. People are drawn into the labor force in numbers
that cannot be sustained indefinitely. Additional members of households
may take a job because of the unusually favorable labor-market conditions.
Some workers may work overtime. Others
may delay retirement or forgo vacations. Maintenance routines that interrupt
production activities may be postponed. These are the aspects of the boom
that allow the economy to produce temporarily beyond the production possibilities
frontier. However, the increasingly binding real resource constraints will
keep the economy from actually reaching the virtual disequilibrium point—hence
the "virtual" quality of that point. The general nature of the path traced
out by the economy—its rotation in the clockwise direction—will become
evident once we consider the corresponding changes in the economy’s structure
of production.
The wedge driven
between saving and investment in the loanable-funds market and the tug-of-war
that pulls the economy beyond its production possibility frontier manifests
itself in the economy’s capital structure as clashing triangles. In the
case of a saving-induced capital restructuring, the derived-demand effect
and the time-discount effect work together to reallocate resources toward
the earlier stages—a reallocation that is depicted by a change in the
shape of the Hayekian triangle. In the case of credit expansion, the two
effects work in opposition to one another. The time-discount effect, which
is strongest in the early stages, attracts resources to long-term projects.
Low interest rates stimulate the creation of durable capital goods, product
development, and other activities whose ultimate payoff is in the distant
future. The excessive allocations to long-term projects are called “malinvestment”
in the Austrian literature. The derived-demand effect, which is strongest
in the late stages, draws resources in the opposite direction so as to
satisfy the increased demand for consumer goods. The Hayekian triangle
is being pulled at both ends against the middle. Skousen (1990) identifies
this same conflict in terms of an early-stage "aggregate supply vector"
and a late-stage "aggregate demand vector."
During the boom,
resource allocations among the various stages are being affected in both
absolute and relative terms. As explained above, the economy is producing
generally at levels of output that cannot be sustained indefinitely. And
at the same time that the overall output levels are higher, the pattern
of output is skewed in both directions—toward the earliest stages and
toward the latest stages. Middle stages experience a relative decline and
some of them an absolute decline. While this characterization of the boom
is gleaned from Hayek (1967 [1935] and Mises (1953 [1912] and 1966), there
remain some fundamental doctrinal differences (both terminological and
substantive) in the alternative expositions offered by these early developers
of capital-based macroeconomics (Garrison, 2004).
Richard Strigl
(2000 [1934]), writing without reference to the Hayekian triangle, provided
an account of boom and bust consistent with the one offered here. In his
account, production activities are divided into three broadly conceived
categories: current production of consumables (late stage), capital maintenance
(middle stage), and new ventures (early stage). Policy-induced boom conditions
tend to favor current production and new ventures at the expense of capital
maintenance. The economic atmosphere has a “make hay while the sun shines”
quality about it, and the economy seems to be characterized by prosperity
and rapid economic growth. However, the under-maintenance of existing capital
(the sparse allocations to the middle stages) distinguishes the policy-induced
boom from genuine, sustainable, saving-induced economic growth.
In time but
before the new ventures (the early-stage activities) have come to full
fruition, the under-maintained capital (the attenuated middle-stage outputs)
must impinge negatively of consumable output. This is the essence of intertemporal
discoordination. The relative or even absolute reduction of consumable
output is dubbed “forced saving” in the Austrian literature. That is,
the pattern of early-stage investment reflects a higher level of saving
than was forthcoming on a voluntary basis. The push beyond the production
possibilities frontier towards the virtual disequilibrium point is cut
short by the lack of genuine saving. The downward rotation of the economy’s
adjustment path in Figure 9.10 reflects the forced saving.
The forced saving
is but one aspect—and not necessarily the first observed aspect—of
the self-reversing process that is characteristic of an artificial boom.
Increasingly binding resource constraints drive up the prices of consumables
as well as the prices of inputs needed to support the new ventures. The
rate of interest rises as overextended businesses bid for additional funding.
Distress borrowing (not shown in Figure 9.10) is a feature of a faltering
boom.
Many of the
new ventures and early-stage activities generally are now recognized as
unprofitable. Some are seen through to completion in order that losses
are minimized. Others are liquidated. The beginning of the liquidation
phase of the business cycle is depicted in Figure 9.10 by economy's adjustment
path turning back towards the production possibilities frontier.
As boom turns
to bust, much of the unemployment is associated with liquidations in the
early stages of production. Too much capital and labor have been committed
to new ventures. The liquidations release these factors of production,
most of which can be reabsorbed—though, of course, not instantaneously—elsewhere
in the structure of production. For the Austrians, this particular instance
of structural unemployment is not something distinct from cyclical
unemployment. Quite to the contrary, the cyclical unemployment that marks
the beginning of the downturn has a characteristically structural quality
about it.
Under the most
favorable conditions, the bust could be followed by a recovery in which
the structural maladjustments induced by the credit expansion are corrected
by the ordinary market forces. The structurally unemployed resources are
reabsorbed where they are most needed, and the economy returns to a point
on its production possibilities frontier. But because of the economywide
nature of the intertemporal disequilibrium, the negative income effect
of the unemployment may initially propel the economy deeper into depression
rather than back to the frontier. This secondary, or compounding, aspect
of the downturn is likely to be all the more severe if the general operation
of markets is countered by macroeconomic policies aimed at preventing liquidation
and at reigniting the boom.
The following
section puts the Austrian theory in perspective by using the capital-based
analytics to depict the Keynesian view of economywide downturns. For Keynes,
the negative income effect that can compound the problem of a discoordinated
capital structure becomes the whole problem, the origins of which are shrouded
in the cloud of uncertainty inherent in investment activities.
9.11 A Keynesian Downturn in the Austrian Framework
The level of aggregation that characterizes the Keynesian framework
precludes any treatment of boom and bust as an instance of intertemporal
discoordination. Structural changes in the economy as might be depicted
by a change in the shape of the Hayekian triangle are no part of the analysis.
The triangle can change only in size, increasing with economic growth (but,
in light of the paradox of thrift, not with saving-induced growth) and
decreasing with occasional lapses from full employment.
The interest
rate plays no role in allocating resources among the stages of production
and only a minor role in determining the overall level of investment. Hence,
investment is treated as a simple aggregate—with the demand for investment
funds taken to be unstable and highly interest inelastic. Further, to the
extent that investment is self-financing, such that increased investment
leads to increased income, which in turn leads to increased saving, the
two curves (saving and investment) shift together and hence the particular
interest-elasticity of investment is irrelevant.
Straightforwardly,
the circular-flow equation (the equality of income and expenditure as an
equilibrium condition) together with a simple consumption function implies
a positively sloped, linear relationship between investment and consumption.
Consider a wholly private economy in which income and expenditures are
in balance:
(9.4)
Y = C + I.
Consumer behavior is described by the conventional linear consumption
equation
(9.5)
C = c0 + mpc Y,
where
c0 is the autonomous component of consumption
spending and mpc is the marginal propensity to consume. Combining
these two equations so as to eliminate the income variable gives us the
relationship between consumption and investment for an economy in a circular-flow
equilibrium.
(9.6)
C = c0 /mps + (mpc/mps) I,
where
mps, of course, is simply the marginal propensity to save:
mps
= 1- mpc. This upward-sloping linear relationship was clearly recognized
by Keynes (1937, pp. 220-21) and can be called the Keynesian demand constraint.
It has an intuitive interpretation that follows straightforwardly from
our understanding of the investment multiplier and the marginal propensity
to consume. Tthe slope of this line is simply the marginal propensity (mpc)
times the multiplier (1/mps). Suppose the mpc is 0.8, implying
an mps of 0.2 and a multiplier of 5. An increase in investment spending
of $100, then, would cause income to spiral up by $500, which would boost
consumption spending by $400. This same result follows directly from the
slope of the demand constraint (mpc/mps = 0.8/0.2 = 4): an
increase in investment of $100 increases consumption by $400.
The Keynesian demand constraint appears in
Figure 9.11, sharing axes with the production possibilities frontier. In
Keynesian expolitions, however, the downward-sloping supply constraint
plays a very limited role. When the multiplier theory is put through its
paces, the frontier serves only to mark the boundary between
real
changes in the spending magnitudes (below the frontier) and nominal
changes in the spending magnitudes (beyond the frontier). Significantly,
the economy is precluded by the demand constraint from moving along
the frontier.
The constraint itself is as stable as the
consumption function—as is clear from its sharing parameters with that
function. Hence the point of intersection of the constraint and the frontier
is the only possible point of full employment. (In the earlier Figure 9.9,
which illustrates the paradox of thrift, the demand constraint shifts downward,
reflecting an increase in saving—and hence a decrease in the consumption
function’s intercept parameter c0 . It was precisely
because of his belief that this parameter was not subject to change
that Keynes was not particularly concerned about the implications of increased
saving.) Finally, we can note that a more comprehensive rendering of the
Keynesian relationships—one that takes into account the demand for money
(i.e., liquidity) as it relates to the interest rate—would alter the
demand constraint only in ways inessential to our current focus.
According to
Keynes (1936, p. 315), economywide downturns characteristic of a market
economy are initiated by sudden collapses in investment demand. The constitutional
weakness on the demand side of the investment-good market reflects the
fact that investments are always made with an eye to the future, a future
that is shrouded in a cloud of uncertainty. Here, the notions of loss of
business confidence, faltering optimism, and even waning “animal spirits”
(Keynes, 1936, pp. 161-62) come into play. In Figure 9.11, the demand for
investment funds collapses: It shifts leftward from D to D’. Reduced
investment impinges on incomes and hence on consumption spending. Multiple
rounds of decreased earning and spending pull the economy below the frontier.
The reduced incomes also translate into reduced saving, as shown by a supply
of loanable funds that shifts from S to S. If the shift in supply just
matches the shift in demand, the rate of interest is unaffected
The solitary
diagram that Keynes presented in his General Theory (p. 180) is
constructed to make this very point. Abstracting from considerations of
liquidity preference, Keynes tells us, the supply of loanable funds
will
shift to match the shift in investment demand. Further, an inelastic demand
for investment ensures that even if the interest-sensitive demand for money
allows for a reduction in the interest rate, the consequences of the leftward
shift in investment demand will be little affected. More to the point of
the present contrast between Keynesian and Austrian views, the economy’s
departure from the production possibility frontier and the leftward shifting
of the supply of loanable funds are but two perspectives on the summary
judgment made by Keynes. The market economy in his view is incapable of
trading off consumption against investment in the face of a parametric
change—in this case, an increased aversion to the uncertainties associated
with investment activities. The economy cannot move along its production
possibilities frontier.
The reduction
in demands all around is depicted by a shrunken Hayekian triangle. With
an unchanged rate of interest, there can be no time-discount effect. Hence,
an untempered derived-demand effect reduces the triangle's size without
changing its shape. But even if, following Keynes, we were to allow for
a change in the rate of interest, the change would be in the wrong direction,
compounding the economic collapse. A scramble for liquidity would
increase
the interest rate with consequences (not shown in Figure 9.11) of further
reduced investment, further reduced incomes, further reduced consumption,
and further reduced saving.
The Austrians
would be on weak grounds if they were to deny even the possibility of a
self-aggravating downward spiral. Markets are at their best in making marginal
adjustments in the face of small or gradual parametric changes. A dramatic
loss of confidence by the business community may well send the economy
into a downward spiral. Axel Leijonhufvud (1981) discusses price and quantity
movements relative to their equilibrium levels in terms of a “corridor.”
Price or quantity deviations from equilibrium that remain within the corridor
are self-correcting; more dramatic deviations that take prices or quantities
outside the corridor can be self-aggravating.
The Austrians
are on firmer grounds to question the notion that such widespread losses
of confidence are inherent in market economies and are to be attributed
to psychological factors that rule the investment community. Business people’s
confidence may instead be shaken by economywide intertemporal discoordination,
which itself is attributable to a prior credit expansion and its consequent
falsification of interest rates. If this is the case, then Keynes’s theory
of the downturn is no more than an elaboration of the secondary contraction
that was already a part of the Austrian theory of boom and bust.
9.12 Inflation and Deflation in the Austrian Theory
The Austrian theory of the business cycle is an account of the credit-induced,
unsustainable boom. The “fundamental mechanisms” mentioned in Hayek’s
assessment of Keynesian constructions are the market forces (time discount
and derived demand) that keep production plans aligned with intertemporal
preferences and that can malfunction when the rate of interest is falsified
by credit expansion. Artificial booms contain the seeds of their own undoing—hence
their fundamental unsustainability.
The reader may
well have noticed that the Austrian theory does not feature the general
rise in prices and wages that may be experienced during a credit-induced
boom. Neither price and wage inflation nor the potential misperceptions
of the inflation rate are fundamental to the theory. The focus instead
is on the misallocation of resources during the period of artificially
cheap credit. Intertemporal discoordination can occur on an economywide
basis, according the Austrians, even during a period of overall price-level
stability. In fact, it is during just such periods that the conflict between
producers and consumers are likely to be hidden until market conditions
in the various stages of production eventually reveal the boom’s unsustainability.
The problem that festers during the boom is likely to go undetected, all
the more so if macroeconomists—and financial markets—take an unchanging
price level to the hallmark of macroeconomic health.
Showing the
particulars of saving-induced growth (Figure 9.8) and of credit-induced
booms (Figure 9.10) made use of the simplifying assumption that we begin
with a no-growth economy. In application, of course, we have to allow for
some ongoing economic growth—and possibly for some fairly high real growth
rate. In a rapidly growing economy, credit expansion may be seen by policymakers
as simply “enabling” growth or possibly as “fostering” growth.
The Austrians take a different view: Credit expansion fosters a little
more growth than can be supported by real saving. The upward pressure on
prices attributable to credit expansion may just offset the downward pressure
on prices attributable to the underlying real growth. Thinking in terms
of the equation of exchange, we can say that increases in M may
just about match increases in Q, such that P remains fairly constant.
While the monetarists would see this price-level stability as evidence
of a successful and commendable application of the monetarist rule, the
Austrians would see price-level constancy during a period of real economic
growth as a warning sign. The monetary rule does not rule out credit-induced
intertemporal discoordination.
The contrast
here between monetarist and Austrian views sheds light on the issue of
the respective theories' applicability. For the monetarists who rely on
Phillips curve analysis (and for new classicists who set out a monetary
misperception theory of the business cycle), booms that lead to busts must
be characterized by inflation. The differential perceptions of inflation
experienced by employers and employees (in the case of Phillips curve analysis)
and the general misperceptions of inflation (in the case of new classical
theory) have as a strict prerequisite that there actually be some inflation
to perceive differentially or to misperceive. These theories, then, cannot
apply to the boom and bust during the interwar period or to the more recent
expansion of the 1990s. In these key cyclical episodes, the inflation rate
was nil (in the former case) and very mild (in the latter). The inflation-dependent
theories apply only to the less dramatic cyclical variations dating from
the late 1960s and extending into the late 1980s. The ability of the Austrian
theory to account for the downturns in 1929 and 2001 would seem to add
to this theory’s credibility.
The Austrian
literature does contain much discussion about inflation. But in connection
with business cycle theory, the strong long-run relationship between the
quantity of money and the overall price level serves to answer a secondary
question about the sustainability of the credit-induced boom. Once the
artificial boom is underway, can the bust be avoided by further credit
expansion? The Austrian answer is that there may be some scope for postponing
the market correction—but only by worsening the root problem of intertemporal
discoordination and hence increasing the severity of the eventual downturn.
In the long run, credit is not a viable substitute for saving. Further,
attempts to prolong the boom through continued increases in credit can
fuel an asset bubble. (Think of the stock market orgy in the late 1920s
and the "irrational exuberance" in the late 1990s.) And, ultimately, increasingly
dramatic injections of credit can set off an accelerating inflation (hyperinflation)
that robs money of its utility.
Deflation, like
inflation, is a secondary issue in the Austrian literature. Growth-induced
deflation, that is, the decline in some overall price index that accompanies
increases in real output, is considered a non-problem. The individual price
reductions occur wherever supply and demand conditions warrant. Here, the
microeconomic forces that govern individual markets are fully in play.
Deflation caused
by a severe monetary contraction is another matter. Strong downward pressures
on prices in general put undue burdens on market mechanisms. Unless, implausibly,
all prices and wages adjust instantaneously to the lower money supply,
output levels will fall. Monetary contraction could be the root cause of
a downturn—as, for instance, it seems to have been in the 1936-1937 episode
in the US. The Federal Reserve, failing to understand the significance
of the excess reserves held by commercial banks, dramatically increased
reserve requirements, causing the money to plummet as banks rebuilt their
cushion of free reserves. But what caused the money supply to fall at the
end of the 1920s’ boom? The monetarists attribute the monetary contraction
to the inherent ineptness of the central bank or to the central bank's
(ill-conceived?) attempt to end the speculative orgy in the stock market,
an orgy that itself goes unexplained.
In the context
of Austrian business cycle theory, the collapse in the money supply is
a complicating factor rather than the root cause of the downturn. In 1929,
when the economy was in the final throes of a credit-induced boom, the
Federal Reserve, uncertain about just what to do and hampered by internal
conflict, allowed the money supply to collapse. The negative monetary growth
during the period 1929 to 1933 helps to account for the unprecedented depth
of the depression. But like Keynes’s focus on the loss of business confidence,
the monetarists’ focus on the collapse of the money supply diverts attention
from the underlying maladjustments in the economy that preceded—and necessitated—the
downturn.
9.13 Policy and Reform
The political attractiveness of the policy prescriptions based on the
Keynesian theory (spending programs, tax cuts, deficit finance, and monetary
expansion) and the absence of a comparable list of politically attractive
policy prescriptions associated with the Austrian theory go a long way
in accounting for the decisive victory in the 1930s of Keynesianism over
Austrianism. Over the following decades, however, the cumulative effects
of the excesses of Keynesian policy (debt monetization and double-digit
inflation) eventually caused monetarism to be seen as the more responsible
alternative. Endorsing monetarism—though not actually institutionalizing
the monetary rule—became politically viable
Although credit
expansion was curtailed in the 1980s, there was never a sustained period
of steady monetary growth at a pre-announced low rate. Further, monetary
reforms enacted in that same period blurred the distinction between money
and other highly liquid assets, making the implementation of the monetary
rule all but impossible. The very definition of money became problematic,
and the once-stable demand for money (as tracked by “velocity” in the
equation of exchange) itself became unstable. By default, the Federal Reserve
reverted to managing interest rates, expanding credit to whatever extent
was necessary to achieve its chosen target rate. With a pro-active central
bank dominating credit markets, the natural rate of interest is a strictly
non-observable rate, but to the extent that the central bank is sensitive
to political considerations, the managed rate is more often than not below
the natural rate.
The Austrians’
policy advice to the central bank consists of prevention rather than cure:
Do not engage in credit expansion—not even if ongoing economic growth
is causing some index of output prices to fall. Abiding by this imperative
is not only politically difficult but also technically difficult—because
the central bank cannot know what the natural rate of interest is and how
it might be changing. The difficulties (both political and technical) of
the central bank’s avoiding a credit-induced boom suggest that what is
needed is fundamental reform rather than policy prescription. Late in his
career, Hayek recommended the Denationalization of Money
(1976).
Subsequent writings by contemporary Austrians—Lawrence H. White (1989)
and George Selgin (1988)—have made the case that a thoroughly decentralized
banking system, one in which the market rate of interest is an unbiased
approximation of the natural rate, may be the ultimate solution to the
problem of boom and bust.
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