The Renaissance of Austrian Economics Coincided with Stagflation and Its Shattering of the Keynesian Paradigm

It was in 1973–1974 that even the Keynesians finally realized that something was very, very wrong with this confident scenario, that it was time to go back in confusion to their drawing boards. For not only had 40-odd years of Keynesian fine-tuning not eliminated a chronic inflation that had set in with World War II, but it was in those years that inflation escalated temporarily into double-digit figures (to about 13 percent per annum). Not only that, it was also in 1973–1974 that the United States plunged into its deepest and longest recession since the 1930s (it would have been called a “depression” if the term hadn’t long since been abandoned as impolitic by economists). This curious phenomenon of a vaunting inflation occurring at the same time as a steep recession was simply not supposed to happen in the Keynesian view of the world. Economists had always known that either the economy is in a boom period, in which case prices are rising, or else the economy is in a recession or depression marked by high unemployment, in which case prices are falling. In the boom, the Keynesian government was supposed to “sop up excess purchasing power” by increasing taxes, according to the Keynesian prescription—that is, it was supposed to take spending out of the economy; in the recession, on the other hand, the government was supposed to increase its spending and its deficits, in order to pump spending into the economy. But if the economy should be in an inflation and a recession with heavy unemployment at the same time, what in the world was government supposed to do? How could it step on the economic accelerator and brake at the same time?

As early as the recession of 1958, things had started to work peculiarly; for the first time, in the midst of a recession, consumer goods prices rose, if only slightly. It was a cloud no bigger than a man’s hand, and it seemed to give Keynesians little to worry about.

Consumer prices, again, rose in the recession of 1966, but this was such a mild recession that no one worried about that either. The sharp inflation of the recession of 1969–1971, however, was a considerable jolt. But it took the steep recession that began in the midst of the double-digit inflation of 1973–1974 to throw the Keynesian economic establishment into permanent disarray. It made them realize that not only had fine-tuning failed, not only was the supposedly dead and buried cycle still with us, but now the economy was in a state of chronic inflation and getting worse—and it was also subject to continuing bouts of recession: of inflationary recession, or “stagflation.” It was not only a new phenomenon, it was one that could not be explained, that could not even exist, in the theories of economic orthodoxy.

And the inflation appeared to be getting worse: approximately 1–2 percent per annum in the Eisenhower years, up to 3–4 percent during the Kennedy era, to 5–6 percent in the Johnson administration, then up to about 13 percent in 1973–1974, and then falling “back” to about 6 percent, but only under the hammer blows of a steep and prolonged depression (approximately 1973–1976).

There are several things, then, which need almost desperately to be explained: (1) Why the chronic and accelerating inflation? (2) Why an inflation even during deep depressions? And while we are at it, it would be important to explain, if we could, (3) Why the business cycle at all? Why the seemingly unending round of boom and bust?

Fortunately, the answers to these questions are at hand, provided by the tragically neglected “Austrian School” of economics and its theory of the money and business cycle, developed in Austria by Ludwig von Mises and his follower Friedrich A. Hayek and brought to the London School of Economics by Hayek in the early 1930s. Actually, Hayek’s Austrian business cycle theory swept the younger economists in Britain precisely because it alone offered a satisfactory explanation of the Great Depression of the 1930s. Such future Keynesian leaders as John R. Hicks, Abba P. Lerner, Lionel Robbins, and Nicholas Kaldor in England, as well as Alvin Hansen in the United States, had been Hayekians only a few years earlier. Then, Keynes’s General Theory swept the boards after 1936 in a veritable “Keynesian Revolution,” which arrogantly proclaimed that no one before it had presumed to offer any explanation whatever of the business cycle or of the Great Depression. It should be emphasized that the Keynesian theory did not win out by carefully debating and refuting the Austrian position; on the contrary, as often happens in the history of social science, Keynesianism simply became the new fashion, and the Austrian theory was not refuted but only ignored and forgotten.

For four decades, the Austrian theory was kept alive, unwept, unhonored, and unsung by most of the world of economics: only Mises (at NYU) and Hayek (at Chicago) themselves and a few followers still clung to the theory. Surely it is no accident that the current renaissance of Austrian economics has coincided with the phenomenon of stagflation and its consequent shattering of the Keynesian paradigm for all to see. In 1974 the first conference of Austrian School economists in decades was held at Royalton College in Vermont. Later that year, the economics profession was astounded by the Nobel Prize being awarded to Hayek. Since then, there have been notable Austrian conferences at the University of Hartford, at Windsor Castle in England, and at New York University, with even Hicks and Lerner showing signs of at least partially returning to their own long-neglected position. Regional conferences have been held on the East Coast, on the West Coast, in the Middle West, and in the Southwest. Books are being published in this field, and, perhaps most important, a number of extremely able graduate students and young professors devoted to Austrian economics have emerged and will undoubtedly be contributing a great deal in the future.

—Murray N. Rothbard, “Inflation and the Business Cycle: The Collapse of the Keynesian Paradigm,” in For a New Liberty: The Libertarian Manifesto, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2006), 214-216.