Mises and Keynes Adopted Different Approaches to Economic Calculation: Mises Used NPV and Keynes Used MEC

The purpose of this paper is to show how Keynesian economics represents a justification for fractional reserve banking and why this justification is fundamentally flawed. In contrast to other examinations of Keynes’s theory, this paper will highlight the marginal efficiency of capital. Like Ludwig von Mises, Keynes was a financial economist who gave economic calculation a central role in his theory. But Mises and Keynes adopted different approaches to economic calculation: Mises used the net present value and Keynes used the marginal efficiency of capital. Importantly, Keynes argued that the marginal efficiency of capital and the net present value yield identical results. Keynes was wrong: the marginal efficiency of capital contradicts the net present value, and, therefore, it is a logically defective approach to economic calculation. Consequently, Keynesian economics is not a viable justification for fractional reserve banking.

—Edward W. Fuller, “Keynes and Fractional Reserve Banking: The NPV vs. MEC,” Procesos de Mercado: Revista Europea de Economía Política 15, no. 1 (Spring 2018): 41-42.

The Theory of Effective Demand Represents Keynes’s Attack on the Loan-Market Theory

 The pre-Keynesian analysis of fractional reserve banking can be illustrated with the loan market theory, the theory of multiple deposit creation, and the net present value. Together, these three theories support 100 percent reserve banking. But Keynes wrote to Irving Fisher, “on the matter of 100 per cent money I have, however, as you know, some considerable reservations.” So how can Keynes reject 100 percent reserves? He accepted the theory of multiple deposit creation, and he accepted the theory of DCF [discounted cash flow] analysis. Thus Keynes’s most obvious departure from the pre-Keynesians was his attack on the loan-market theory.

The Keynesian theory has three components: (1) the theory of effective demand, (2) the liquidity preference theory, and (3) the marginal efficiency of capital. The theory of effective demand represents Keynes’s attack on the loan-market theory. As noted, in the loan-market theory, the interest rate is the price that adjusts to balance saving and investment. However, Keynes explicitly rejected the theory. Instead, in his theory of effective demand, the level of income is the factor that adjusts to equalize saving and investment. If investment is greater (less) than saving, then income will rise (fall) until saving equals investment. In the Keynesian theory, income replaces the interest rate as the equilibrator of saving and investment.

—Edward W. Fuller, “Keynes and Fractional Reserve Banking: The NPV vs. MEC,” Procesos de Mercado: Revista Europea de Economía Política 15, no. 1 (Spring 2018): 54.

The Central Issue in Macroeconomic Theory Is the Extent to which the Economy May Be Regarded as a Self-Regulating System

The central issue in macroeconomic theory is the extent to which the economy, or at least its market sectors, may properly be regarded as a self-regulating system. While the general belief in the superiority of self-regulating, polycentric, market-based economic systems had undoubtedly been intensified since the collapse of the former Soviet Communist system, now two decades ago, in the field of money and banking authoritative economists still adopt a radically different stance, and go on developing proposals for what are essentially new variants of central planning in monetary matters. 

While it is today seldom contested that we can rely on self-regulating, decentralized, market-based systems as far as the production and allocation of commodities in general — such as automobiles, computers etc. — is concerned, in the field of money and banking the monocentric presupposition still almost universally prevails: in order to function properly the monetary and banking system has to be constantly monitored by a central agency, viz. by the central bank. A number of economists have nevertheless recognized the inconsistency implicit in this special treatment of the monetary and banking sectors as contrasted with economic issues in general, and have developed models of decentralized monetary and banking systems which are supposed to function as polycentric, self-regulating orders. While the general direction of this branch of research can be welcomed with some enthusiasm, the ways in which the “details” of some of the better known proposals for “free banking” have been elaborated until present, remain subject to a certain amount of well-founded criticism. The recent republication by the Ludwig von Mises Institute of Larry Sechrest’s Free Banking offers an opportunity to draw special attention to two particular claims revealed by the argumentation off the free bankers which struck this author as rather questionable. 

—Ludwig van den Hauwe, “Free Banking, the Real-Balance Effect, and Walras’ Law,” Procesos de Mercado: Revista Europea de Economía Política 7, no. 1 (Spring 2010): 242-243.

Keynes Transformed Fractional Reserve Bankers from Economic Villains Who Cause Depressions into Economic Heroes Who Enrich Society

Many critics of John Maynard Keynes attribute the success of his ideas to political appeal. No doubt, politicians are attracted to Keynesian economics because it can be used to justify profligate government spending. While important, political appeal alone cannot totally explain his triumph. Since Keynes’s theory is purportedly an economic theory, it could have never prevailed without the economists. So why does Keynes’s theory attract so many economists, and the most influential economists in particular? The answer is that influential economists in the banking system are attracted to Keynesian economics because it can serve as an economic justification for fractional reserve banking. The Keynesian interpretation of fractional reserve banking is an important reason Keynes’s theory conquered the economics profession.

Economists were becoming increasingly critical of fractional reserve banking in the years before Keynes published his theory. Even Alfred Marshall, the founder of the Cambridge school of economics, argued fractional reserve banking amplifies the business cycle. In 1912, Ludwig von Mises showed that fractional reserve banking is the fundamental cause of the business cycle. The Great Depression led many eminent American economists, including Irving Fisher, Frank Knight, Henry Simons, and Jacob Viner, to advocate abolishing fractional reserve banking. In fact, it was the American backlash against fractional reserves in the early 1930s that led directly to the formation of the Chicago school of economics. During the Great Depression, Senator Bronson Cutting and other politicians in the United States introduced legislation to abolish fractional reserve banking. 

Keynes’s theory was a godsend for the defenders of fractional reserves. Pre-Keynesian economics showed fractional reserve banking causes the business cycle and thereby makes society poorer than it otherwise would be. Before The General Theory of Employment, Interest and Money (1936), the defenders of fractional reserve banking had no answer to the pre-Keynesian analysis. But Keynes gave defenders of fractional reserves a weapon with which to combat the pre-Keynesian analysis. While the pre-Keynesian theory shows fractional reserve banking destroys wealth, the seemingly scientific New Economics purports to show that it is good for the economy. Rather than impoverishing society, fractional reserve banking actually creates prosperity in Keynes’s system. In short, Keynes transformed fractional reserve bankers from economic villains who cause depressions into economic heroes who enrich society. It is no wonder so many influential economists in the banking system have enthusiastically adopted Keynes’s theory.

—Edward W. Fuller, “Keynes and Fractional Reserve Banking: The NPV vs. MEC,” Procesos de Mercado: Revista Europea de Economía Política 15, no. 1 (Spring 2018): 40-41.

Hayek’s “Profit, Interest and Investment” (1939) Is a Theoretical Explanation of the High and Persistent Unemployment of the 1930s

It is usually assumed that, while John Maynard Keynes developed a theory of chronic unemployment, Friedrich August Hayek did not. Indeed, a theory like this one was never explicitly explained by Hayek. 

However, we defend “Profit, Interest and Investment” (1939a) was written as a theoretical explanation of the high and persistent unemployment of the 1930s. We believe that the assumptions chosen by Hayek reveal that intention: “We shall start here from an initial situation where considerable unemployment of material resources and labor exists, and we shall take account of the existing rigidity of money wages and of the limited mobility of labor. More specifically, we shall assume throughout this essay that (. . . ) money wages cannot be reduced (. . . )and finally, that the money rate of interest is kept constant.” These assumptions are similar to the institutional and macroeconomic conditions of the British economy in the late 1930s. Besides, these assumptions are radically different from those chosen in Prices and Production (1931). In that book, Hayek assumed as a starting point in his discussion, a) full employment, b) labor mobility, c) flexible wages and d) flexible rate of interest. Thus, we believe that Hayek tried to adapt his model to the new circumstances. 

We will argue in this paper that this essay could be interpreted as a theory of chronic unemployment and economic stagnation. Also, it will be defended that this phenomenon has its explanation in a dynamically inefficient design of some of the institutions that rule the market.

—David Sanz and Juan Morillo, “The Hayekian Theory of Chronic Unemployment,” Procesos de Mercado: Revista Europea de Economía Política 15, no. 1 (Spring 2018): 14.

Neoclassical Theory is Just the “Liberal” and Mathematical Version of the Intellectual Mistake of Central Planning

According to the Austrian vision, a dynamic equilibrium, in which human actions try to coordinate in order to accomplish the plans, is possible to be reached only if actions are free. This doesn’t mean that all the plans will be reached and we can obtain a static and perfect equilibrium like in the neoclassical theory. But, in a free society the people are free to learn from their mistakes, so they are free to amend their plans and expectations, according to what they learn from the mistakes and from the interaction with other people.

According to the socialist view, instead, it is possible for a central planner to collect all data in order to produce a perfect economic calculation. In this way, it is the central authority that supplies the information to the actors in terms of prices, goods to be produced, quantities, etc… These idea became so common during the 1920s and 30s, that a certain degree of central planning was widely accepted outside from the Marxist environment. Keynes is the most important example, while the neoclassical theory is the “liberal” and mathematical version of this intellectual mistake.

For more than half a century, the belief that deliberate regulation of all social affairs must necessarily be more successful than the apparent haphazard interplay of independent individuals has continuously gained ground until to-day there is hardly a political group anywhere in the world which does not want central direction of most human activities in the service of one aim or another. (Hayek, 1935a, p. 1).

—Carmelo Ferlito, “Bruno Leoni and the Socialist Economic Calculation Debate,” Procesos de Mercado: Revista Europea de Economía Política 10, no. 1 (Spring 2013): 38-39.

The “Hayekian Triangle” Is a Faulty Tool Because “Stages of Production” Is a Confused Concept

Although the concept of “stages of production” is often illustrated by an example; e.g., mining, refining, manufacturing, distributing, and retailing, this is not analytically satisfactory. These are but arbitrary categories. Any specific production process can be broken down into ever more discrete stages, or combined into fewer of them. The limit to the number of stages is set only by the number of individual human actions involved. Thus, the number of stages depends upon the judgment of the individual decision maker analyst. This is not to deny that the concept may be useful in providing the flavor of production through time, but it is not analytically sound in the sense necessary to be measured along the horizontal axis of a triangle that purports to represent the structure of production from an analytical (in this case, geometrical, and, therefore, mathematical) perspective.

Further, these examples are intrinsically confusing. Consider steel in this regard. If anything “deserves” to be located in an early stage of production, this item certainly does: it is the backbone of so much else, and these other productions cannot take place until the steel comes along on line. However, steel also occurs in very late orders of production. Indeed, steel may be found throughout the structure of production. For example, it is used pretty much at every stage in the production of bread, and its delivery to the final consumer. So, where does steel properly go? At an early stage of production? All through out?

—William Barnett II and Walter Block, “On Hayekian Triangles,” Procesos de Mercado: Revista Europea de Economía Política 3, no. 2 (Autumn 2006): 59-60.