The Macroeconomics of Captial Structure
Roger W. Garrison
The Long and the Short of It
In early 1997 a small group of world-class economists, serving as panelists in a session of the American Economics Association meetings, addressed themselves to the question "Is there a core of practical macroeconomics that we should all believe?" We could hardly imagine that a second group of economists were gathered across the hall to answer a similar question about microeconomics. Dating from the marginalist revolution of the 1870s, microeconomics has had a readily recognizable core-and one that has grown increasingly solid over the past century. By contrast, the Keynesian revolution that began in the 1930s ushered in a macroeconomics that was-at least from one important point of view-essentially coreless. The capital theory that underlay the macroeconomics being developed by the Austrian school was no part of Keynesian theory.
"One major weakness in the core of macroeconomics," as identified by AEA panelist Robert Solow (1997, p. 231f), "is the lack of real coupling between the short-run picture and the long-run picture. Since the long run and the short run merge into one another [sic], one feels that they cannot be completely independent." Ironically, when the same Robert Solow (1997b, p. 594) contributed an entry on Trevor Swan to An Encyclopedia of Keynesian Economics, he took a much more sanguine view: [Swan's writings serve] as a reminder that one can be a Keynesian for the short run and a neoclassical for the long run, and that this combination of commitments may be the right one."
The present volume takes Solow's more critical assessment to be the more cogent. The weakness, or lacking, in modern macroeconomic theorizing can most easily be seen by contrasting Keynes's macroeconomics with Solow's own economics of growth. In the short run, the investment and consumption magnitudes move in the same direction-both downward into recession or both upward toward full employment and even beyond in an inflationary spiral. The economics of growth, which also allows investment and consumption to increase together over time, features the fundamental trade-off faced in each period between current consumption and investment. We can increase investment (and hence increase future consumption) if and to the extent we are willing to forgo current consumption. For a given period and with a given technology, any change in the economy's growth rate must entail consumption and investment magnitudes that move, initially, in opposite directions.
So, can we accept or find practical use for a macroeconomics (1) in which consumption and investment always move together in the short run, (2) in which these two magnitudes must move in opposition to change the economy's rate of growth, and (3) for which the long run emerges as a seamless sequence of short runs?
Keynes (1936, p. 378), whose demand-dominated theory offered us nothing in the way of a "real coupling," simply refocused the profession's attention on the short-run movements in macroeconomic magnitudes while paying lip service to the fundamental truths of classical economics: "if our central controls succeed in establishing an aggregate volume of output corresponding to full employment as nearly as is practicable, the classical theory comes into its own again from this point onward." This statement comes immediately after his claim that the "tacit assumptions [of the classical theory] are seldom or never satisfied."
The classical economists, if we are to accept Keynes's caricature of them, focused their attention exclusively on the long-run relationships, as governed by binding supply-side constraints, and relied on Say's Law ("Supply creates its own Demand," in Keynes's rendering) to keep the Keynesian short run out of the picture.
If Keynes focused on the short-run picture, and the classical economists focused on the long-run picture, then the Austrian economists, and particularly Friedrich. A. Hayek, focused on the "real coupling" between the two pictures. The Hayekian coupling took the form of capital theory-the theory of a time-consuming, multi-stage capital structure envisioned by Carl Menger and developed by Eugen von Böhm-Bawerk. Decades before macroeconomics emerged as a recognized subdiscipline, Böhm-Bawerk had molded the fundamental Mengerian insight into a macroeconomic theory to account for the distribution of income among the factors of production. Dating from the late 1920s, Hayek, following a lead provided by Ludwig von Mises, infused the theory with monetary considerations. He showed that policy activism practiced by the monetary authority can be a source of economywide distortions in the intertemporal allocation of resources and hence an important cause of business cycles.
Tellingly, Robert Solow, as revealed in an interview with Jack Birner (1990, p. 28n.) found Hayek's work to be "completely incomprehensible." A major claim in the present book is that Hayek's work-and the work of modern Austrian macroeconomists-can be comprehended as an effort to reinstate the capital-theory "core" that allows for a "real coupling" of short-run and long-run aspects of the market process. Hayek, in effect, anticipated and heeded a warning issued by Mises (1949, p. 284): "[W]e must guard ourselves against the popular fallacy of drawing a sharp line between short-run and long-run effects. What happens in the short run is precisely the first stages of a chain of successive transformations which tend to bring about the long-run effects."
The question addressed by the AEA panelists in 1997 is but an echo of a lingering question about the nature of macroeconomic problems posed by John Hicks (1967, p. 203) three decades earlier: "[Who] was right, Keynes or Hayek?" The most recent answer to Hicks' question is offered by Bruce Caldwell in his introduction to Contra Keynes and Cambridge, (Volume 9 of the Collected Works of F. A. Hayek). According to Caldwell (1995, p. 46), "neither was right. Both purported to be supplying a general theory of the cycle, and in this, neither was successful." This verdict can be called into question on two counts. First, Chapter 22 of Keynes's General Theory, "Notes on the Trade Cycle," is not advertized as a general theory of the cycle, and the remainder of Keynes's book is concerned primarily with secular unemployment and only secondarily if at all with cyclical variations. Second, although Hayek's Prices and Production and related writings were concerned primarily with cyclical variation, applicability took priority over generality. Hayek's focus (1967, p. 54) on a money-induced artificial boom reflects the fact that, as an institutional matter and as an historical matter, money enters the economy through credit markets. Hence, it impinges, in the first instance, on interest rates and affects the intertemporal allocation of resources. He recognized that a fully general theory would have to encompass other institutional arrangements and allow for other possible boom-bust scenarios.
But there is a greater point that challenges Caldwell's answer. The major weakness that Solow saw in modern macroeconomics has as its counterpart in Austrian macroeconomics a major strength. There is a real coupling between the short run and the long run in the Austrian theory. The fact that the Austrian economists feature this coupling is the basis for an alternative answer to Hicks' question: Hayek was right. Or, more substantively, identifying the relative-price effects (and the corresponding quantity adjustments) of a monetary disturbance, as compared to tracking the movements in macroeconomic aggregates that conceal those relative-price effects, gives us a superior understanding of the nature of cyclical variation in the economy and points the way to a more thoroughgoing capital-based macroeconomics.
What's in a Name?
The subtitle of this book, The Macroeconomics of Capital Structure, is intended to suggest that the macroeconomic relationships identified and explored here are, to a large extent, complementary to the relationships that have dominated the thinking of macroeconomists for the past half century. Arguably, the macroeconomics of labor, which is the focus of modern income-expenditure analysis, and the macroeconomics of money, which gets emphasis in the quantity-theory tradition, have each been pushed well into the range of diminishing marginal returns. If further pushing toward a fuller macroeconomic understanding is to pay, it may well involve paying attention to the economy's intertemporal capital structure.
In a more comprehensive and balanced treatment of the issues, we might want to present a macroeconomics of labor, capital, and money. This trilogy is sequenced so as to parallel the title chosen by Keynes: The General Theory of Employment, Interest, and Money. Capital does not appear in his trilogy, but its shadow, interest, does. The lack of conformability in Keynes's identification of the objects of study-employment (of labor), capital's shadow, and money-should alert us at the outset to the enduring perplexities that theorizing about capital and interest entails. Classical economists saw the rate of interest, also known as the rate of profit, as the price of capital. Keynes, who clearly rejected this view, would have us believe that the shadow is actually being cast by money. Keynes's critics, particularly the members of the Austrian school, took the rate of interest to be a systematic discounting of future values-whether or not capital was involved in creating them or money was involved in facilitating their exchange. Decades of controversy have demonstrated that the interest rate's relationship to capital and to money is not a simple one. In the present study, capital-or, more pointedly, the intertemporal structure of capital-is the primary focus. The centrality of the interest rate derives from its role in allocating resources-and sometimes in misallocating them-within the economy's capital structure.
Undeniably, claims can be made to justify each of the three candidates (labor, capital and money) as an appropriate basis, or primary focal point, for macroeconomic theorizing. The rationale for labor-based macroeconomics and for money-based macroeconomics are more often assumed than actually spelled out. The case for capital-based macroeconomics, however, is, at least, an equally compelling one.
Labor-Based Macroeconomics The employment
of labor is logically and temporally prior to the creation of capital.
Capital goods, after all, are produced by labor. Even the macroeconomic
theorists who have devoted the most attention to capital have typically
identified labor, together with natural resources, as the "original" means
of production. And although the employment of labor in modern economies
is facilitated by a commonly accepted medium of exchange, the use of money
is not fundamentally a prerequisite to employment. The employment of labor
can take place in a barter economy, and self-employment in a Crusoe economy.
Employee compensation accounts for a large portion-more than seventy percent-of national income even in the most capital-intensive economies. The earning and spending by workers, then, dominates in any circular-flow construction. The occasional widespread unemployment in modern economies is the most salient manifestation of a macroeconomic problem. And cyclical variation in economic activity is conventionally charted in terms of changes in the unemployment rate. The pricing of labor even in markets that may otherwise be characterized by flexibility can be affected by attitudes about fairness, implications for worker morale, and considerations of firm-specific human capital. Hence, changes in labor-market conditions can result in quantity adjustments and/or price adjustments not fully accounted for by simply supply-and-demand analysis. All these considerations give employment a strong claim to being the primary focus for macroeconomic theorizing.
Money-Based Macroeconomics It is the use of money, arguably, that puts the macro in macroeconomics. In the context of a barter system, it is difficult even to imagine-unless we think of a widespread natural disaster-that the economy might experience variations in market conditions that have systematic economywide repercussions. But, with trivial exceptions, money is on one side of every transaction in modern economies. Unavoidably, however, the medium of exchange is also a medium through which difficulties in any sector of the economy-or difficulties with money itself-get transmitted to all other sectors. Further, the provision of money even in the most decentralized economies is-not to say must be-the business of a central authority. This institutionalized centrality translates directly into a central concern of macroeconomists. Money comes into play both as a source of difficulties and as a transmission of those difficulties. Using terminology first introduced by Ragnar Frisch, we can say that money matters both as "impulse" and as "propagation mechanism." So involved is money that macroeconomics and monetary theory have, in some quarters, come to be thought as two names for the same set of ideas. Monetarism, broadly conceived, is simply money-based macroeconomics.
Capital-Based Macroeconomics What, then, is
the case for capital-based macroeconomics? Considerations of capital structure
allow the time element to enter the theory in a fundamental yet concrete
way. If labor and land can be thought of as original means of production
and consumer goods as the ultimate end toward which production is directed,
then capital occupies a position that is both logically and temporally
intermediate between original means and ultimate ends. The goods-in-process
conception of capital has a long and honorable history. And even forms
of capital that do not fit neatly into a simple linear means-ends framework,
such as fixed capital, human capital, and consumer durables, occupy an
intermediate position between some relevant production decisions and the
corresponding consumption utilities.
This temporally intermediate status of capital is not in serious dispute, but its significance for macroeconomic theorizing is rarely recognized. Alfred Marshall taught us that the time element is central to almost every economic problem. The critical time element manifests itself in the Austrian theory as an intertemporal capital structure. The scope and limits to structural modifications give increased significance to monetary disturbances. Simply put, capital gives money time to cause trouble. In a barter economy, there is no money to cause any trouble; in a pure exchange economy, there is not much trouble that money can cause. But in a modern capital-intensive economy,....
The macroeconomic significance of the fact that production takes time suggests that, for business-cycle theory, capital and money should get equal billing. The nature and significance of money-induced price distortions in the context of a time-consuming production processes was the basis for my early article "Time and Money: the Universals of Macroeconomic Theorizing" (1984)-and for the title of the present book. Macroeconomic theorizing, so conceived, is a story about how things can go wrong-how the economy's production process that transforms resources into consumable output can get derailed. Sometime subsequent to the committing of resources but prior to the emergence of output, the production process can be at war with itself; different aspects of the market process that governs production can working against one another. Thus, the troubles that characterize modern capital-intensive economies, particularly the episodes of boom and bust, may best be analyzed with the aid of a capital-based macroeconomics.
An Exercise in Comparative Frameworks
This book was originally conceived as a graphical exposition of boom and bust as understood by the Austrian school. In its writing, however, the horizon was extended in two directions. First, a theory of boom and bust became capital-based macroeconomics. The relationships identified in pursuit of the narrower subject matter proved to be a sound basis for a more encompassing theory, one that sheds light upon such topics as deficit spending, credit controls, and tax reform. The general analytical framework that emerges from the insights of the Austrian school qualifies as a full-fledged Austrian macroeconomics. Chapter 3 sets out the capital-based framework; Chapter 4 employs it to depict the Austrian perspective on economic growth and cyclical variation; Chapter 5 extends the analysis from monetary matters to fiscal matters and develops still other applications; Chapter 6 offers a variation on the Austrian theme by introducing risk and uncertainty and making a distinction-in connection with the distribution of risk and exposure to uncertainty-between preference-based choices and policy-induced choices.
Second, the task of setting out and defending a capital-based (Austrian) macroeconomics requires a conformable labor-based (Keynesian) macroeconomics with which to compare and contrast it. The comparison was not well facilitated by the existing renditions of conventional macroeconomics-the Keynesian cross, ISLM, and Aggregate-Supply/Aggregate-Demand. Fortunately, it was possible to create a labor-based macroeconomic framework that remains true to Keynes (truer, arguably, than the more conventional constructions) and that contains important elements common to both (Keynesian and Austrian) frameworks. The resulting exercise in comparative frameworks requires a second set of core chapters. Chapter 7 sets out the labor-based framework; Chapter 8 employs it to depict the Keynesian view of cyclical variation and of counter-cyclical policies; Chapter 9 shifts the focus from stabilization policy to social reform.
As it turns out, money-based macroeconomics is virtually framework-independent. Any framework that tracks the quantity of money, the economy's total output, and the price level can be used to express the essential propositions of Monetarism. However, two separate strands of Monetarism can be identified-one that offers a theory of boom and bust and one that denies, on empirical grounds, that the boom-bust sequence has any claim on our attention. Both strands can be set out with the aid of either the labor-based framework (We're all Keynesians, now) or the capital-based framework (A close reading of Milton Friedman reveals elements of Austrianism). Chapters 10 deals with the Monetarists' view of boom and bust; Chapter 11 deals with depression as monetary disequilibrium.
The intertemporal structure of capital gets a strong emphasis throughout the book-an emphasis that some might judge to be unwarranted. But this book emphasizes the structure of capital in the same sense and in the same spirit that Friedman's work emphasizes the quantity of money or that the New Classical economists emphasize expectations. We tend to emphasize what we judge to have been unduly neglected in earlier writings. Chapter 12 summarizes and puts capital-based macroeconomics into perspective.
The emphasis in macroeconomics during the final quarter of the twentieth century has clearly been-not on labor, not on capital, not on money-but on expectations, so much so that theories tend to be categorized and judged primarily in terms of their treatment of expectations. Static expectations are wholly inadequate; adaptive expectations are only marginally less so; the assumption of rational expectations has become a virtual prerequisite for having any other aspect of a macroeconomic construction taken seriously. There is something troubling, however, about the notion of an expectations-based macroeconomics. Readers of Lewis Carrol and Dennis Robertson will sense a certain grin-without-the-cat flavor to modern treatments of expectations. Chapter 2 deals head on with the issue of expectations in the context of the development of macroeconomics over the last three-quarters of a century and argues that there has been an overemphasis on expectations in modern theory which is ultimately attributable to the corelessness of modern macroeconomics, to the lack of "real coupling," as identified by Solow, between short-run and long-run macroeconomic relationships, or-more concretely-to the failure to give due attention to the economy's intertemporal capital structure.
Point of Departure and Style of Argument
F. A. Hayek's contribution to the development of capital theory is commonly regarded as his most fundamental and path-breaking achievement (Machlup, 1976). His early attention to "Intertemporal Price Equilibrium and Movements in the Value of Money" (1928; English translation in Hayek, 1984) provided both the basis and inspiration for many subsequent contributions. The widely recognized but rarely understood Hayekian triangle, introduced in his 1931 lectures at the University of London, were subsequently published (in 1931 with a second edition in 1935) as Prices and Production. The triangle, as described in the second lecture (Hayek, 1967, pp. 36-47), is a heuristic device that gives analytical legs to a theory of business cycles first offered by Ludwig von Mises (1953, pp. 339-366). Triangles of different shapes provide a convenient but highly stylized way of describing changes in the intertemporal pattern of the economy's capital structure.
In retrospect we see that the timing of Hayek's invitation to lecture at the University of London takes on a special significance. We learn from the preface of the subsequent book that had the invitation come earlier, he couldn't have delivered those lectures; had it come later, he probably wouldn't have delivered them. "[The invitation] came at a time when I had arrived at a clear view of the outlines of a theory of industrial fluctuations but before I had elaborated it in full detail or even realized all the difficulties which such an elaboration presented" (Hayek, 1967, p. vii). Hayek mentions plans for a more complete exposition and indicates that his capital theory would have to be developed in much greater detail and adapted to the complexities of the real world before it could serve as a satisfactory basis for theorizing about cyclical fluctuations.
A decade after the London lectures the more complete exposition took form as The Pure Theory of Capital (1941). In this book Hayek fleshed out the earlier formulations and emphasized the centrality of the "capital problem" in questions about the market's ability to coordinate economic activities over time. The "pure" in the title meant "preliminary to the introduction of monetary considerations." Though some 450 pages in length, the book achieved only the first half of the original objective. The final sixty pages of the book did contain a "condensed and sketchy" (p. viii) treatment of the rate of interest in a money economy, but the task of retelling the story in Prices and Production in the context of the Pure Theory of Capital was put off and ultimately abandoned. The onset of the war was the proximate reason for cutting the project short; Hayek's exhaustion and waning interest in the business-cycle issues-and his heightened interest in the broader issues of political philosophy-account for his never returning to the task. In later years he acknowledged that Austrian capital theory effectively ended with his 1941 book and lamented that no one else has taken up the task that he had originally set for himself (White, 20?? drawing from Hayek, 1994, p. 96).
More fully developing the Austrian theory of the business cycle came to be synonymous with writing the follow-on volume to Hayek's Pure Theory. Many a graduate student has imagined himself undertaking that very project, only to abandon the idea even before the enormity of the task was fully comprehended. Thus, while the comparatively simple relationships of capital-free Keynesian theory captured the attention of the economics profession, the inherently complex relationships of Austrian theory languished.
Time and Money is not the follow-on volume to Hayek's Pure Theory. Rather, the ideas and graphical constructions in the present volume take the original Hayekian triangle of Prices and Production to be the more appropriate point of departure for creating a capital-based macroeconomics. The trade-off between simplicity and realism is struck in favor of simplicity. Hayek's triangles allow us to make a graphical statement that there is a capital structure and that its intertemporal profile can change. This statement enables the Austrian theory to make a quantum leap beyond the competing theories that ignore capital altogether or that treat capital as a one-dimensional magnitude.
It is true, of course, that the triangles leave much out of account, but so too-despite their complexity-do the Pure Theory's warped pie-slice figures that are intended to make some allowance for durable capital (Hayek, 1941, pp. 208 and 211). Degrees of realism range from K (for capital) to an aerial photograph of the Rust Belt. K is too simple; everything from the Pure Theory to the aerial photograph is too realistic for use in a macroeconomic framework. The Hayekian triangle is just right. It is comparable-in terms of the simplicity/realism trade-off-to the Keynesian cross; and it is comparable in this same regard to other graphical devices (the production-possibilities frontier, the market for loanable funds, and markets for labor) that make up the capital-based framework. Sophomores in their first economics course sometimes complain about all the considerations that the a simple Marshallian demand curve fails to capture. As they reel off a list of particulars, the professor waits patiently to deliver the news: "What's remarkable about demand curves is not that they leave so much out of account but that they account for so much on the basis of so little." The same point is an appropriate response to those critical of Hayekian triangulation.
The style of argument in Time and Money may appear to some as strangely anachronistic-as theory from the 1930s and pedagogy from the 1960s. This appearance is not without significance. The theory is from the 1930s because it was during that period that capital theory was dropped out of macroeconomics. The pedagogy is reminiscent of the 1960s because Austrian macroeconomics is missing the stage of development that the alternative (Keynesian) macroeconomics was pacing through during that decade. The sequence of frameworks from the Keynesian cross to ISLM to Aggregate-Supply/Aggregate-Demand has no counterpart in Austrian macroeconomcis. Instead, we have the Hayekian triangle accompanied by critical assessments and apologetic defenses, followed in time with the Pure Theory, which was and unfinished task and strategic miscue, followed by years of neglect. In recent years there has been a scatter of restatements of the Austrian theory, many of which are contorted by the near-obligatory attention to the current concerns of mainstream macroeconomics, such as expectations and lag structure. Not surprisingly, there can be only limited success in reintroducing the old Austrian insights into a macroeconomics whose development over the past half-century has followed an alternative course. Accordingly, if the constructions and argumentation in Time and Money are throwbacks and partially remedial in nature, they are unapologetically so.
Modern Austrian theory is not some hardened set of ideas or even an generally agreed upon set of agenda items. There are members of the school who have long turned a blind eye to the issues of business cycles and of macroeconomics more broadly conceived. Classics in Austrian Economics: A Sampling in the History of a Tradition, edited by Israel Kirzner (1994), gives little or no hint that the Austrian economists ever asked a macroeconomic question, let alone offered answers that show great insight and much promise for development. And while Kirzner himself has contributed importantly to the development of capital theory, primarily in his Essays on Captial and Interest: An Austrian Perspective (1996), he has steered clear of macroeconomics. His introductory essay includes a brief assessment of the progress on this front: "[R]ecent Austrian work on Hayekian cycle theory [and presumably on Austrian macroeconomics generally] seems, on the whole, to fail to draw on the subjectivist, Misesian, tradition which the contemporary Austrian resurgence has done so much to revive" (p. 2). Karen Vaughn's Austrian Economics in America: The Migration of a Tradition leaves the impression that macroeconomics never reached-or possibly shouldn't have reached-the American shore. And in her recent reflections on the development of the Austrian tradition (1999, p. ??), she hints that progress is to be measured in part by the school's distancing itself from the issues of business cycles and the gold standard.
The capital-based macroeconomics offered in this volume is bolstered by the judgment of Machlup that Hayek's contribution to capital theory was both fundamental and path-breaking and by the belief that a macroeconomic framework that features the Austrian theory of capital can compare favorably to the alternative frameworks of mainstream macroeconomics.