Say's Law of Markets and the Meaning of “Supply CONSTITUTES Demand”

I shall suggest that, fairly interpreted, “Say's law of markets” survives as the most fundamental “economic law” in all economic theory. It enunciates the principle that “demands in general” are “supplies in general”—different aspects of one phenomenon.

Today's textbooks usually express Say's law most carelessly, using a description of the law which, I think, Keynes was the first to use. It asserts, they tell their readers (without mentioning Keynes) that “supply creates its own demand.” But the supply of plums does not create the demand for plums. And the word “creates” is injudicious. What the law really asserts is that the supply of plums constitutes demand for whatever the supplier is destined to acquire in exchange for the plums under barter, or with the money proceeds in a money economy. (The supplier may of course hold on to the money, i.e., demand it instead of other non-money).

—William H. Hutt, introduction to A Rehabilitation of Say's Law (Athens, OH: Ohio University Press, 1974), 3.

J. S. Mill's 4th Proposition on Capital Should Be Understood as a Continuation of the General Glut Debate

John Stuart Mill’s Fourth Fundamental Proposition Respecting Capital, first stated in 1848, had become an enigma well before the nineteenth century had come to an end. Never challenged in Mill’s own lifetime and described in 1876 as “the best test of a sound economist,” it has become a statement that not only fails to find others in agreement, but fails even to find an internally consistent interpretation that would make clear why Mill found it of such fundamental importance. Yet the fourth proposition should be easily understood as a continuation of the general glut debate. Economists led by Malthus had argued that demand deficiency was the cause of recession and a body of unproductive consumers was needed to raise the level of demand if everyone who wished to work was to find employment. Mill’s answer was that to buy goods and services would not increase employment, or, in Mill’s own words, “demand for commodities is not demand for labour.”

—Steven Kates, “Mill's Fourth Fundamental Proposition on Capital: A Paradox Explained,” abstract, Journal of the History of Economic Thought 37, no. 1 (March 2015): 39.

Industry Is Limited by Capital, BUT There Is NO Upper Limit to Production Imposed on the Demand Side

In Chapter V, Mill provides four propositions with regard to capital which are in his view fundamental for anyone wishing to understand the workings of an economy. The first proposition is that ‘industry is limited by capital’ (John Stuart Mill's Principles of Political Economy, 63), of which he wrote:

While, on the one hand, industry is limited by capital, so on the other, every increase of capital gives, or is capable of giving, additional employment to industry; and this without assignable limit. (Ibid.: 66)

In other words, there is no upper limit to production imposed on the demand side. This was the fundamental issue in question during the debates over the validity of the law of markets, and it was to this section of the chapter (pp. 66-8) that Mill referred during his more comprehensive discussion in Book III, Chapter XIV. Mill contrasts this view with the views held by others:

There is not an opinion more general among mankind than this, that the unproductive expenditure of the rich is necessary to the employment of the poor. Before Adam Smith, the doctrine had hardly been questioned; and even since his time, authors of the highest name and great merit have contended, that if consumers were to save and convert into capital more than a limited portion of their income, and were not to devote to unproductive consumption an amount of means bearing a certain ratio to the capital of the country, the extra accumulation would be merely so much waste, since there would be no market for the commodities which the capital so created would produce. (Ibid.: 66-7)

That is, if unproductive consumers decided to invest instead, and therefore used their capital productively rather than merely consuming it, beyond some upper limit the additional output produced would fail to find buyers. Production, on this view, can therefore rise faster than demand, a situation which only an increase in unproductive spending can forestall. It is this proposition which the law of markets was designed to refute.

—Steven Kates, Say's Law and the Keynesian Revolution: How Macroeconomic Theory Lost its Way (Cheltenham, UK: Edward Elgar Publishing, 2009), 69.

The Second Fundamental Theorem Respecting Capital Is: Capital Is the Result of Saving

A second fundamental theorem respecting Capital relates to the source from which it is derived. It is the result of saving. The evidence of this lies abundantly in what has been already said on the subject. But the proposition needs some further illustration.

If all persons were to expend in personal indulgences all that they produce, and all the income they receive from what is produced by others, capital could not increase. All capital, with a trifling exception, was originally the result of saving. I say, with a trifling exception; because a person who labours on his own account may spend on his own account all he produces, without becoming destitute; and the provision of necessaries on which he subsists until he has reaped his harvest, or sold his commodity, though a real capital, cannot be said to have been saved, since it is all used for the supply of his own wants, and perhaps as speedily as if it had been consumed in idleness. We may imagine a number of individuals or families settled on as many separate pieces of land, each living on what their own labour produces, and consuming the whole produce. But even these must save (that is, spare from their personal consumption) as much as is necessary for seed. Some saving, therefore, there must have been, even in the simplest of all states of economical relations; people must have produced more than they used, or used less than they produced. Still more must they do so before they can employ other labourers, or increase their production beyond what can be accomplished by the work of their own hands. All that any one employs in supporting and carrying on any other labour than his own, must have been originally brought together by saving; somebody must have produced it and forborne to consume it. We may say, therefore, without material inaccuracy, that all capital, and especially all addition to capital, is the result of saving.

—John Stuart Mill, Principles of Political Economy with Some of Their Applications to Social Philosophy, ed. W. J. Ashley (1909; repr., London: Longmans, Green and Co., 1936), 68-69.

The True Function of a Positive Rate of Interest Is to Act As an Intertemporal Brake

³Larry Moss has directed my attention to a passage in Mark Blaug’s Economic Theory in Retrospect (1985 [1962]) in which Blaug sets out Böhm-Bawerk’s theory of capital and interest using the “brake” metaphor: “The true function of a positive rate of interest then is to act as a brake on the tendency to neglect present wants by overextending the period of production” (p. 505). The Austrian interest rate as an intertemporal brake stands in sharp contrast to the neoclassical interest rate as a reflection of capital’s productivity. What the interest rate actually reflects, according to the Austrians, is people’s reluctance to forgo enough current consumption to take the fullest advantage of time-consuming production processes.

—Roger W. Garrison, “From Keynes to Hayek: The Marvel of Thriving Macroeconomies,” Review of Austrian Economics 19, no. 1 (March 2006): 11n.

Richard Cantillon's Analysis of the Price-Specie-Flow Mechanism Is Superior to David Hume's Analysis

Hume's most important contribution is his elucidation of monetary theory, in particular his clear exposition of the price-specie-flow mechanism that equilibrates national balances of payments and international price levels. In monetary theory proper, Hume vivifies the Lockean quantity theory of money with a marvellous illustration, highlighting the fact that it doesn't matter what the quantity of money may be in any given country: any quantity, smaller or larger, will suffice to do money's work of facilitating exchange. Hume pointed up this important truth by postulating what would happen if every individual, overnight, should find the stock of money in his possession to have doubled miraculously:

For suppose that, by miracle, every man in Great Britain should have five pounds slipped into his pocket in one night; this would much more than double the whole money that is at present in the kingdom; yet there would not next day, nor for some time, be any more lenders, nor any variation in the interest.

Prices then, following Locke's quantity theory of money, will increase proportionately.

The price-specie-flow mechanism is the quantity theory extrapolated into the case of many countries. The rise in the supply of money in country A will cause its prices to rise; but then the goods of country A are no longer as competitive compared to other countries. Exports will therefore decline, and imports from other countries with cheaper goods will rise. The balance of trade in country A will therefore become unfavourable, and specie will flow out of A in order to pay for the deficit. But this outflow of specie will eventually cause a sharp contraction of the supply of money in country A, a proportional fall in prices, and an end to, indeed a reversal of, the unfavourable balance. As prices in A fall back to previous levels, specie will flow back in until the balance of trade is in balance, and until the price levels in terms of specie are equal in each country. Thus, on the free market, there is a rapidly self-correcting force at work that equilibrates balances of payments and price levels, and prevents an inflation from going very far in any given country.

While Hume's discussion is lucid and engaging, it is a considerable deterioration from that of Richard Cantillon. First, Cantillon did not believe in aggregate proportionality of money and price level changes, instead engaging in a sophisticated micro-process analysis of money going from one person to the next. As a result, money and prices will not rise proportionately even in the eventual new equilibrium state. Second, Cantillon included the ‘income effect’ of more money in a country, whereas Hume confined himself to the aggregate price effect. In short, if the money supply in country A increases, it will equilibrate not only by prices rising in A, but also by the fact that monetary assets and incomes are higher in A, and therefore more money will be spent on imports. This income or more precisely, the cash balance, effect will generally work faster than the price effect.

—Murray N. Rothbard, An Austrian Perspective on the History of Economic Thought, vol. 1, Economic Thought Before Adam Smith (Auburn, AL: Ludwig von Mises Institute, 2006), 426-427.

“Rational Expectations” Theories Explicitly Acknowledge the Postulate of “Money Neutrality”

The theoretical revolution dubbed ‘rational expectations’, which occurred around mid-1970s, came to reinforce the classical dichotomy [between monetary/nominal values and real values] that had already been dominating economic thought for over two centuries. The introduction of expectations of variations in the purchasing power of money was grounded on the postulate that economic agents can understand the connection between money and the price level. On the assumption that economic agents do not suffer from the ‘money illusion’, rational expectations theories expected them to be able to sieve through market signals and discriminate between nominal and real changes. Lucas (1975) and Sargent and Wallace (1976) therefore concluded that only real changes affect real decisions, and that variations in the purchasing power of money are neutralized if correctly anticipated (McCallum 1980)—not only in the long run, but in the short run as well (Kaldor 1970; Lines and Westerhoff 2010). The dichotomy between the monetary and the real sectors of the economy was in this way restated in even stronger terms, with the postulate of money neutrality explicitly acknowledged.

—Carmen Elena Dorobăț, “Cantillon Effects in International Trade: The Consequences of Fiat Money for Trade, Finance, and the International Distribution of Wealth” (PhD diss., Université d'Angers, 2015), 53.

Mises Agrees with Lachmann's Criticism: The ABCT Does Indeed Assume Elastic Expectations

In the thirty-one years which have passed since the first edition of my Theory of Money and Credit was published no tenable argument has been raised against the validity of what is commonly called the “Austrian” theory of the credit cycle. It was easy to prove that all objections brought forward were either futile or founded on a mistaken interpretation of the doctrine attacked.

However, some remarks made by Dr. L. M. Lachmann in his recent article “The Rôle of Expectations in Economics as a Social Science” deserve careful consideration. In this thoughtful essay the author contends that “the Wicksellian theory appears to be based on a very special assumption, viz., of a capital market without a very strong mind of its own, always ready to follow a lead on the spur of the moment, and easily led into mistaking an ephemeral phenomenon for a symptom of a change in the economic structure. Without fairly elastic expectations there can be no crisis of the Austro-Wicksellian type.” I fully agree with this statement with exception of the use of the term “elastic,” which I would rather avoid as it implies an inadequate and misleading mechanical metaphor; furthermore, I believe that the word “boom” should be substituted for the word “crisis.”

But I want to point out that I did not fail to state the fact that my explanation of the trade cycle is based on such an assumption. In my treatise Nationaloekonomie (Geneva, 1940) the chapter dealing with credit expansion ends with the following observation: “This typical course of the trade cycle has sometimes been altered through the interference of extraordinary events, mostly of a political character. But by and large one can observe in Great Britain since the end of the 18th century and in Western and Central Europe and in North America since the middle of the 19th century an almost regular alternation of booms and depressions. We may wonder whether the conditions which have had this result still prevail. The teachings of the monetary theory of the trade cycle are to-day so well known even outside of the circle of economists, that the naïve optimism which inspired the entrepreneurs in the boom periods has given way to a greater scepticism. It may be that business men will in future react to credit expansion in another manner than they did in the past. It may be that they will avoid using for an expansion of their operations the easy money available, because they will keep in mind the inevitable end of the boom. Some signs forebode such a change. But it is too early to make a positive statement.”

—Ludwig von Mises, “‘Elastic Expectations’ and the Austrian Theory of the Trade Cycle,” Economica, n.s., 10, no. 39 (August 1943): 251.

The Austrian Business Cycle Theory Requires a Special Assumption Concerning the Elasticity of Expectations

If inelastic expectations are really as frequent and important as some writers would have us believe, an interesting problem arises with regard to the interpretation of Wicksellian theory, more particularly in its Austrian version. According to this doctrine booms and slumps are engineered by banks lowering the “money rate of interest” below its “natural level,” or raising it above it. Whatever the precise meaning of these terms, we now know that if banks are to succeed in altering the long-term rate of interest, expectations have to be very elastic. Seen from this angle, the Wicksellian theory appears to be based on a very special assumption, viz. of a capital market without a very strong mind of its own, always ready to follow a lead on the spur of the moment, and easily led into mistaking an ephemeral phenomenon for a symptom of a change in the economic structure. Without fairly elastic expectations there can therefore be no crisis of the Austro-Wicksellian type. But again, before we can accept this theory we are entitled to hear an explanation why elastic expectations should be prevalent. Such a gullible capital market we should expect to find in an economy the structure of which is still highly fluid and in which long-run forces have not yet had time to take shape. We tentatively suggest that such a state of expectations may be typical of an economy in the early stages of industrialisation, or of an economy undergoing “rejuvenation” owing to rapid technical progress.

—Ludwig M. Lachmann, “The Role of Expectations in Economics as a Social Science,” in Capital, Expectations, and the Market Process: Essays on the Theory of the Market Economy, ed. Walter E. Grinder (Kansas City: Sheed Andrews and McMeel, 1977), 78-79.

Men Do Not Really Act in the Ricardian World, They Merely Re-act to Their Circumstances

The main aim of the present-day Cambridge School appears to be an attempt to undo the results of the marginal revolution and to bring about a Ricardian counter-revolution. For a hundred years economists have taken it for granted that what happens in a market economy ultimately depends on the subjective preferences and expectations of millions of individuals finding expression in the supply and demand for goods, services and financial assets. If we accept this approach we are compelled to pay close attention to the differences between human preferences and the divergence of expectations. If not, we are presumably free to turn our attention to facts supposedly ‘socially objective’. In a world in which differences of preferences and divergence of expectations do not matter there is, of course, no room for entrepreneurs. . . .

For them economic action always means the response of a ‘typical agent’ to a ‘given’ situation. Men act exclusively in their capacity as ‘workers’, ‘capitalists’, or ‘landlords’. Spontaneous action does not exist. Men do not really act in the Ricardian world, they merely re-act to the circumstances in which they happen to find themselves. It is thus hardly surprising that the neo-Ricardian understanding of the ways in which a market economy functions is somewhat limited, and subjectivism is seen as nothing but an aberration from the true path of economic thought. Ricardo can be said to have thought essentially in long-run equilibrium terms. So it is not surprising to find that macro-economic formalism is a style of thought congenial to his latter-day disciples.

—Ludwig M. Lachmann, Macro-economic Thinking and the Market Economy: An Essay on the Neglect of the Micro-foundations and Its Consequences, Hobart Paper 56 (London: Institute of Economic Affairs, 1973), 18-19.

New Capital Can Be Formed Exclusively by “Free Capital”

We will now distinguish between three forms of capital:

1. Free capital: This is the subsistence fund (supply of consumer goods) which is made available for the support of roundabout methods of production;
2.  Intermediate products: These are raw materials in the various stages of processing prior to the finishing of the consumer good (raw materials take on the shape of “maturing” consumer goods in the course of processing);
3.  Fixed (stable) capital: (“relatively durable factors of production”: machines, etc.); These are produced factors of production that can be used for a number of individual production processes.

Intermediate products and fixed capital are goods which are characteristic of roundabout methods of production. We will label them with the term “capital goods.” In contrast, consumer goods as such are never capital; they only assume the function of capital if they are used in the specific way we previously described with the term “reproductive consumption,” i.e., if they serve to support roundabout methods of production. Intermediate products and free capital serve to support the individual production processes and can thus be labeled “liquid” capital in contrast to “fixed” capital. Yet, one must pay attention to the fact that liquid capital is also employed in the process of producing fixed capital.

The production process at work in roundabout methods of production is determined by the employment of these three forms of capital. The fact that originary factors of production can initially be used in the production of intermediate products which mature only in the course of time into finished products, is made possible by a supply of free capital. A special form of roundabout method of production is present if in addition—and this again is only possible under the condition of a supply of free capital—originary factors of production are employed in the production of fixed capital, which later in turn produces the finished product by incorporating intermediate products and additional originary factors of production. However, because the production of a capital good is only possible with the help of a subsistence fund which supports a process that has not yet produced any consumer goods, every capital good must have been preceded by free capital. The capital good is produced as a result of the expenditure of free capital.

Thus, new capital can be formed exclusively by free capital. New capital can only come into existence because finished consumer goods are “saved” and employed so that they permit the choice of a roundabout method of production. This not only applies to the case of building up new capital, intended to increase the economy's supply of capital; it also applies to the renewal of all capital that has been invested in the economy. Every roundabout process of production begins with the investment of free capital, and every further step in the production process implies a new expenditure of free capital.

—Richard von Strigl, Capital and Production, trans. Margaret Rudelich Hoppe and Hans-Hermann Hoppe, ed. Jörg Guido Hülsmann (Auburn, AL: Ludwig von Mises Institute, 2000), 27-28.

The First Fundamental Proposition Respecting Capital: Industry Is Limited by Capital

The first of these propositions is, that industry is limited by capital. This is so obvious as to be taken for granted in many common forms of speech; but to see a truth occasionally is one thing, to recognise it habitually, and admit no propositions inconsistent with it, is another. The axiom was until lately almost universally disregarded by legislators and political writers; and doctrines irreconcilable with it are still very commonly professed and inculcated. . . .

Yet, in disregard of a fact so evident, it long continued to be believed that laws and governments, without creating capital, could create industry. Not by making the people more laborious, or increasing the efficiency of their labour; these are objects to which the government can, in some degree, indirectly contribute. But without any increase in the skill or energy of the labourers, and without causing any persons to labour who had previously been maintained in idleness, it was still thought that the government, without providing additional funds, could create additional employment. A government would, by prohibitory laws, put a stop to the importation of some commodity; and when by this it had caused the commodity to be produced at home, it would plume itself upon having enriched the country with a new branch of industry, would parade in statistical tables the amount of produce yielded and labour employed in the production, and take credit for the whole of this as a gain to the country, obtained through the prohibitory law. Although this sort of political arithmetic has fallen a little into discredit in England, it still flourishes in the nations of Continental Europe. Had legislators been aware that industry is limited by capital, they would have seen that, the aggregate capital of the country not having been increased, any portion of it which they by their laws had caused to be embarked in the newly-acquired branch of industry must have been withdrawn or withheld from some other; in which it gave, or would have given, employment to probably about the same quantity of labour which it employs in its new occupation.

—John Stuart Mill, Principles of Political Economy with Some of Their Applications to Social Philosophy, ed. W. J. Ashley (1909; repr., London: Longmans, Green and Co., 1936), 53-54.

Ludwig von Mises on John Stuart Mill and the Literature of (Classical) Liberalism

John Stuart Mill is an epigone of classical liberalism and, especially in his later years, under the influence of his wife, full of feeble compromises. He slips slowly into socialism and is the originator of the thoughtless confounding of liberal and socialist ideas that led to the decline of English liberalism and to the undermining of the living standards of the English people. Nevertheless—or perhaps precisely because of this— one must become acquainted with Mill’s principal writings:

• Principles of Political Economy (1848)
• On Liberty (1859)
• Utilitarianism (1862)

Without a thorough study of Mill it is impossible to understand the events of the last two generations, for Mill is the great advocate of socialism. All the arguments that could be advanced in favor of socialism are elaborated by him with loving care. In comparison with Mill all other socialist writers —even Marx, Engels, and Lassalle—are scarcely of any importance. 

—Ludwig von Mises, appendix to Liberalism: The Classical Tradition, ed. Bettina Bien Greaves (Indianapolis: Liberty Fund, 2005), 153-154.

The Meaning of the Law of Markets Can Be Understood ONLY through Mill's Definition of Capital

But to understand Mill's meaning with regard to Say's Law fully, it is necessary to turn to Book I, Chapter V, Mill's famous chapter on ‘Fundamental Propositions Respecting Capital.’ Indeed, the appropriate place to start is the discussion on the meaning of capital in the previous chapter (Book I, Chapter IV) because, as with the essay, it is only through following Mill's definition of capital that the meaning of the law of markets can be understood. Capital, according to Mill, is everything and anything an entrepreneur intends to utilise to earn income. There is nothing intrinsic in an item which makes it capital, but only the intention of its owner. Capital includes not only all tangible goods, but also money and available lines of credit:

The distinction, then, between Capital and Not-capital, does not lie in the kind of commodities, but in the mind of the capitalist — in his will to employ them for one purpose rather than another; and all property, however ill adapted in itself for the use of labourers, is a part of capital so soon as it, or the value to be received from it, is set apart for productive reinvestment. The sum of the values so destined by their respective possessors, composes the capital of the country.

In Chapter V, Mill provides four propositions with regard to capital which are in his view fundamental for anyone wishing to understand the workings of an economy.

—Steven Kates, Say's Law and the Keynesian Revolution: How Macroeconomic Theory Lost its Way (Cheltenham, UK: Edward Elgar Publishing, 2009), 68-69.

Theories of Interest Based on Productivity Are a Remnant of the Objectivist Conception of Value

Böhm-Bawerk also considers theories which, like Clark’s, base interest on the marginal productivity of capital to be untenable. In fact, according to Böhm-Bawerk, theorists who claim that interest is determined by the marginal productivity of capital are unable to explain, among other points, why competition among the different entrepreneurs does not tend to cause the present value of capital goods in the market to match that of their expected output, thus eliminating any value differential between costs and output throughout the production period. As Böhm-Bawerk correctly indicates, the theories based on productivity are merely a remnant of the objectivist conception of value, according to which value is determined by the historical cost incurred in the production processes of different goods and services. However prices determine costs, not vice versa, and knowledge of this fact reaches at least as far back as Luis Saravia de la Calle. Economic agents incur costs because they believe that the value they will be able to obtain from the consumer goods they produce will exceed these costs. The same principle applies to each capital good’s marginal productivity, which is ultimately determined by the future value of the consumer goods and services the capital good helps to produce. By a discount process this value yields the present market value of the capital good (which is completely unrelated to its cost of production).

—Jesús Huerta de Soto, The Austrian School: Market Order and Entrepreneurial Creativity (Cheltenham, UK: Edward Elgar, 2008), 56-57.

The Underconsumption Myth Is Untenable Even If One Accepts the “Exploitation” Doctrine As Correct

In speaking of underconsumption, people mean to describe a state of affairs in which a part of the goods produced cannot be consumed because the people who could consume them are by their poverty prevented from buying them. These goods remain unsold or can be swapped only at prices not covering the cost of production. Hence various disarrangements and disturbances arise, the total complex of which is called economic depression.

Now it happens again and again that entrepreneurs err in anticipating the future state of the market. Instead of producing those goods for which the demand of the consumers is most intense, they produce less urgently needed goods or things which cannot be sold at all. These inefficient entrepreneurs suffer losses while their more efficient competitors who anticipated the wishes of the consumers earn profits. The losses of the former group of entrepreneurs are not caused by a general abstention from buying on the part of the public; they are due to the fact that the public prefers to buy other goods.

If it were true, as the underconsumption myth implies, that the workers are too poor to buy the products because the entrepreneurs and the capitalists unfairly appropriate to themselves what by rights should go to the wage earners, the state of affairs would not be altered. The “exploiters” are not supposed to exploit from sheer wantonness. They want, it is insinuated, to increase at the expense of the “exploited” either their own consumption or their own investments. They do not withdraw their booty from the universe. They spend it either in buying luxuries for their own household or in buying producers’ goods for the expansion of their enterprises. Of course, their demand is directed toward goods other than those the wage earners would have bought if the profits had been confiscated and distributed among them.

Entrepreneurial errors with regard to the state of the market of various classes of commodities as created by such “exploitation” are in no way different from any other entrepreneurial shortcomings. Entrepreneurial errors result in losses for the inefficient entrepreneurs which are counterbalanced by the profits of the efficient entrepreneurs. They make business bad for some groups of industries and good for other groups. They do not bring about a general depression of trade.

The underconsumption myth is baseless self-contradictory balderdash. Its reasoning crumbles away as soon as one begins to examine it. It is untenable even if one, for the sake of argument, accepts the “exploitation” doctrine as correct.

—Ludwig von Mises, Human Action: A Treatise on Economics, ed. Bettina Bien Greaves (Indianapolis: Liberty Fund, 2007), 2:301-302.

J. B. Clark's Capital Theory Caused Böhm-Bawerk To Predict the Revival of Underconsumptionism

In general the neoclassical school has followed a tradition which predated the subjectivist revolution and involves a productive system in which the different factors of production give rise, in a homogeneous and horizontal manner, to consumer goods and services. No thought whatsoever is given to the immersion of these factors in time and space throughout a temporal structure of productive stages, an aspect Austrian theorists typically do take into account. The above static framework provided the structure for the work of John Bates Clark (1847–1938), who carried it to its logical conclusion. Clark was Professor of Economics at Columbia University in New York, and his strong anti-subjectivist reaction in the area of capital and interest theory continues even today to serve as the foundation for the entire neoclassical-monetarist edifice. . . .

Böhm-Bawerk reacted immediately against the objectivist stance of Clark and his school. For instance, Böhm-Bawerk describes Clark’s concept of capital as “mystical” and “mythological”, pointing out that production processes never depend upon a mysterious, homogeneous fund, but instead invariably rely on the joint operation of specific capital goods which entrepreneurs must always first conceive, produce, select and combine within an economic process that takes time. Furthermore, according to Böhm-Bawerk, Clark views capital as a sort of “value jelly”, or fictitious notion. With remarkable foresight, Böhm-Bawerk warned that acceptance of such an idea was bound to lead to grave errors in the future development of economic theory. Indeed Böhm-Bawerk predicted with great prescience that if Clark’s circular, static model were to prevail, the long-discredited doctrines of underconsumption would inevitably revive, and when Keynes and his school appeared, Böhm-Bawerk was proven right (Böhm-Bawerk 1895).

—Jesús Huerta de Soto, The Austrian School: Market Order and Entrepreneurial Creativity (Cheltenham, UK: Edward Elgar, 2008), 55-56.

Modern Textbooks on Macroeconomics Rarely Mention Cantillon and His Contributions to Business Cycle Theory

Since his rediscovery by Jevons in the late nineteenth century, the economics profession has applauded Cantillon as a methodologist and theorist of the first and highest order. However, the main body of the economics profession has largely ignored his work on business cycles. In fact, modern textbooks on macroeconomics rarely, if ever, make any mention of Cantillon and his contributions in this area. This neglect is puzzling given the profession’s lack of consensus on what causes business cycles and given that one of Cantillon’s primary reasons for inventing economics was to explain the cause of the business cycle and the events surrounding the Mississippi Bubble.

Hébert (1985) first suggested that Cantillon presented the “germ” of Austrian business cycle theory à la Hayek’s work on prices and production, and Hayek himself lauded Cantillon’s contributions and insights. Rothbard (1995) also found that Cantillon provided the “first hint” of Austrian business cycle theory, but Hülsmann (2001) contended that even this acknowledgment understated Cantillon’s contribution, despite Cantillon’s failure to offer a full-blown version of the Austrian business cycle theory. The contention here is that Cantillon provided a cogent theory of business cycles, where cycles are caused by government manipulation of money and banking. Furthermore, he anticipated the key features of the Austrian approach in that his analysis is based on the non-neutrality of money, artificial changes to relative prices, and the resulting alterations in consumption, production, and investment decisions that ultimately are revealed to be harmful for the economy. On the key issues of theory, Cantillon clearly falls into the Austrian camp. Nowhere do we find him emphasizing psychological or irrational causes of the business cycle, such as animal spirits or bandwagon effects; and while money is clearly important, Cantillon downplayed the usefulness of the quantity theory of money and attacked the whole notion of government control of the money supply. Rather than emphasizing a stable purchasing power of money, Cantillon emphasized the Austrian point that any given quantity of money will be sufficient.

—Mark Thornton, “Cantillon on the Cause of the Business Cycle,” Quarterly Journal of Austrian Economics 9, no. 3 (Fall 2006): 46.

Endogenous Expectations Present a Compelling Alternative to Exogenous Theories of Expectations

There would be no business cycle without government artificially expanding credit. Although it may be true that distorted signals were created through government involvement, the critics say, to pin everything on government intervention implies a type of perfect markets theory where there are never any bubbles or systemically inaccurate expectations. But what about the hundreds of bubbles across countries and throughout history (Kindleberger and Aliber 2011)? Surely government intervention did not cause all of them. And if some bubbles occur without government intervention, why not all of them? These critics claim that business cycles are driven by market excesses, not by government intervention (Keynes 2006 [1936], Krugman 2000; Shiller 2006; Minsky and Kaufman 2008; Akerlof and Shiller 2010; Kindleberger and Aliber 2011).

Incorporating endogenous expectations into ABCT [Austrian Business Cycle Theory] answers these critics. By recognizing why people engage in speculation, make seemingly foolish, unrealizable plans, and how markets usually restrain this behavior, Austrian theorists can better explain exactly how government policies contribute to naturally occurring asset bubbles. Understanding how people form expectations highlights how governments often replace limited self-correcting asset bubbles with large bubbles by distorting entrepreneurs’ and consumers’ expectations. We need to understand how people interpret relative price changes, particularly with respect to their expectations of future prices. Unfortunately the mechanisms for how and why expectations change are largely ignored.

This paper sketches a theory, in the tradition of Menger, Mises, and Hayek, that expectations are endogenous to market processes and institutions. Endogenous expectations present a compelling alternative to exogenous theories of expectations, particularly rational expectations. It also forms the basis for an Austrian response to the “irrational exuberance” and “animal spirits” theories advanced by Shiller (2006) and Akerlof and Shiller (2010). Although many Austrians understand the importance of expectations (Mises 2009 [1912], 1949; Lachmann 1943; Wagner 1999; Garrison 2001; Carilli and Dempster 2001; Evans and Baxendale 2008), an analytical theory of expectations remains largely absent from their theorizing. Surveying recent Austrian treatments of the 2008 financial crisis reveals little interest or awareness of the role played by individuals’ interpretive frameworks or expectations.

—Paul D. Mueller, “An Austrian View of Expectations and Business Cycles,” Review of Austrian Economics 27, no. 2 (June 2014): 200.

Productivity and Time Preference Are Highly Important But Have Very Different Functions

In journal articles on capital, interest and rent written largely between 1900 and 1914 (Fetter 1977), and particularly in two treatises on economic principles (Fetter 1904, 1915), Fetter built upon Böhm-Bawerk and the Austrian School to develop a lucid and remarkable integrated structure of economic theory. He was able to accomplish this feat by purging economics of all traces of Ricardian or other British objectivist theories of value and distribution, in particular any differential theories of rent or productivity theories of interest.

Much of Fetter’s achievement rested on his insight into the ordinary language meaning of ‘rent’ as simply the price of any durable good per unit time. He was then able to show that the prices of consumer goods are determined by their marginal utilities, and that these values are imputed back to determining the rental prices of factors of production by their marginal value productivity in serving consumers. The capital value, or price of the whole good (whether land, capital goods, or, Fetter might have added, the labourer under slavery) is then determined by the sum of its expected future returns, or rents, discounted by the social rate of time preference, or rate of interest. Thus, Fetter went beyond Böhm-Bawerk by arriving at a pure time preference theory of interest. Productivity and time preference are both highly important, but they have very different functions: the former in determining rents, and the latter determining the rate of interest. Thus, future rents are discounted by the rate of time preference and summed up, or ‘capitalized’, into their present capital value. Indeed, Fetter often called his contribution the ‘capitalization theory of interest’.

—Murray N. Rothbard, “Frank Albert Fetter (1863-1949),” in The New Palgrave Dictionary of Economics, 3rd ed. (London, UK: Palgrave Macmillan, 2018), 4540.

It Is the Fact of Time Preference that Results in Interest and Profit

Again working from analysis of the individual, Böhm-Bawerk saw that it was a basic law of human action that each person wishes to achieve his desires, his goals, as quickly as possible. Hence, each person will prefer goods and services in the present to waiting for these goods for a length of time in the future. A bird already in the hand will always be worth more to him than one bird in the bush. It is because of this basic primordial fact of “time preference” that people do not invest all their income in capital equipment so as to increase the amount of goods that will be produced in the future. For they must first attend to consuming goods now. But each person, in different conditions and cultures, has a different rate of time preference, of preferring goods now to goods later. The higher their rate of time preference, the greater the proportion of their income they will consume now; the lower the rate, the more they will save and invest in future production. It is the fact of time preference that results in interest and profit; and it is the degree and intensity of time preferences that will determine how high the rate of interest and profit will be.

—Murray N. Rothbard, The Essential von Mises (Auburn, AL: Ludwig von Mises Institute, 2009), 9.

Frank Fetter Points Out the Major Contradiction in Böhm-Bawerk's Theory of Interest

Critics of the Positive Theory have frequently declared in effect that, while its author had ejected the productivity of capital from the front yard of his theory, he had opened to it the side door and had given it the freedom of the house. For what place are we to assign in the broad theory of interest to the “productiveness of the roundabout process”? Is it the main and fundamental, or is it only a supplementary and partial, explanation of the cause of interest? The essay under review certainly puts it in the central and leading place: it is the greater productiveness of labor when applied in a long and roundabout way which is the great and efficient cause of interest on capital. If that is not the impression left on the reader of this essay, and the one the author intends to leave, then we have missed its purpose. And yet this is out of harmony, first, with the author's own strong negative criticisms of productivity theories as affording only incomplete answers to the interest problem and, secondly, with his formal statement of the theory of interest as due to the difference between the value of present and that of future goods.

—Frank A. Fetter, “Review of Böhm-Bawerk, Einige strittige Fragen der Capitalstheorie,” in Capital, Interest, and Rent: Essays in the Theory of Distribution, ed. Murray N. Rothbard (Kansas City: Sheed Andrews and McMeel, 1977), 89-90.

The Trade-Off Between More Roundabout Ways of Production and the Needs of Present Consumption

Eugen von Böhm-Bawerk took over Menger’s (1871) discussion of the role of time in the production process and built his theory of interest upon it. Böhm-Bawerk (1889) too defined capital physically and in relation to the time-consuming production process, namely as ‘the complex of intermediate products which appear on the several stages’ of production. He also clearly worked out an important cornerstone of the Austrian theory of capital: the trade-off between more roundabout ways of production and the needs of present consumption. On the one hand, he argued, in the spirit of Menger (1871), production leads to better results when (wisely chosen) more roundabout (i.e. time-consuming) methods encompassing more intermediate stages of production are employed (Böhm-Bawerk, 1889). On the other hand, the ability of entrepreneurs to implement more roundabout methods of production is limited. There must be a fund of consumption goods — what Böhm-Bawerk called subsistence-fund — which supports the owners of the factors of production while the more roundabout production processes are getting installed (Böhm-Bawerk, 1889).

With this trade-off, Böhm-Bawerk outlined the problem area around which many later contributions to Austrian capital theory would revolve. Most notably, the Austrian Business Cycle Theory (ABCT) as developed by Mises (1912) and expanded on by Strigl (1934), Hayek (1935), Rothbard (1962) and Garrison (2001) is based on this aspect: absent productivity gains, a reduction in consumption is needed to lengthen the structure of production and to undertake more roundabout ways of production. If people do not save more yet the banking system, by artificially lowering the interest rate, makes entrepreneurs believe that savings have increased, the production structure is ‘lengthened’ despite a lack of savings. But this degree of roundaboutness seems to be sustainable because the interest rate is below its equilibrium or natural level; ultimately, these too roundabout methods of production prove to be unsustainable and their abandonment or truncation triggers an economic crisis.

—Eduard Braun, Peter Lewin, and Nicolás Cachanosky, “Ludwig von Mises's Approach to Capital As a Bridge between Austrian and Institutional Economics,” Journal of Institutional Economics 12, no. 4 (December 2016): 850-851.

Macrotheorizing Is Dangerously Simplistic and Policy Should Not Be Guided by Macroeconomic Theory

As the principal academic rival to Keynes in the 1930s, Hayek had argued that macrotheorizing was dangerously simplistic:

every attempt to find a statistical measure in the form of a general average of the total volume of production, or the total volume of trade, or general business activity or whatever we may call it, will merely result in veiling the really significant phenomenon, the changes in the structure of production. (Hayek 1935)

and he continued to warn against allowing policy to be guided by macroeconomic theory: “I fear that those who believe that we have solved the problem of permanent full employment are in for a serious disillusionment” (Hayek 1978). In a further prescient comment during the stagflation of the 1970s, Hayek’s assertion was that “[t]he Keynesian dream is gone even if its ghost will continue to plague politics for decades” (Hayek 1975). To be fair, the difficulty for politicians is that the electorate judges them largely upon the basis of economic performance; and, although the evidence is soundly against political intervention—the old adage goes “There is no situation so bad that government intervention cannot make it worse”—it is rare for a politician to accept that truth.

The economy is complex and macroeconomics is simplistic. Yet, macroeconomic analysis provides the only theoretical basis upon which to forecast the economic trends that are the stuff of politics. And, although there is a good living to be made by the more astute economists, macroeconomic analysis and forecasts are inherently implausible:

[t]he appearance and growth of unemployment in an inflationary period shows only too clearly that employment is not simply a function of total demand but is determined by that structure of prices and production that only micro-theory can help us to understand. (Hayek 1978)

—G. R. Steele, “Are Macroeconomic Theorists Rational?” Quarterly Journal of Austrian Economics 10, no. 2 (Summer 2007): 10-11.

Friendly Approaches to the Rational Expectations Challenge to the Austrian Business Cycle Theory

According to the rational expectations critique, for instance, as found in Caplan (1997) and Tullock (1988, 1989), the theory needs to explain how otherwise rational entrepreneurs are so easily deceived by a publicly known monetary policy. . . . If entrepreneurs had rational expectations, they would not produce systematic errors. . . .

Broadly speaking, the answers to the rational expectations challenge to the ABCT can be divided into two groups: (1) A friendly approach to the rational expectations critique that acknowledges a need for revision but concludes that the theory still holds and (2) a less friendly approach that maintains that the problem does not lie with the theory but with the initial rational expectations assumption.

The first group can be represented by Carilli and Dempster (2001) and Evans and Baxendale (2008), who treat the rational expectation critique as a “valid challenge and accept the fundamental claim that in its present form the Austrian theory requires revision.”

Carilli and Dempster’s (2001) argument is that the expansive monetary policy of the monetary authority places the entrepreneurs and banks in a prisoner’s dilemma. In short, seizing capital gains during a boom by investing in long-term and capital intensive projects and selling them to other investors before the boom ends is rational behavior. Because this exposition falls within the framework of the prisoner’s dilemma, the rational behavior is implicitly embedded in the exposition.

Evans and Baxendale (2008) accept the rational expectations challenge but argue that because entrepreneurs are heterogeneous, the cluster of errors is driven not by a representative entrepreneur but by entrepreneurs on the margin. For Evans and Baxendale (2008), the critic still must offer a convincing explanation why entrepreneurs can be assumed to be homogeneous. Even if the entrepreneurial heterogeneity argument may put Evans and Baxendale (2008) between the two groups, they still offer a friendly reception to the rational expectations challenge.

—Nicolas Cachanosky, “Expectation in Austrian Business Cycle Theory: Market Share Matters,” Review of Austrian Economics 28, no. 2 (June 2015): 153.