To Graphically See How the Interest Rate Regulates the Intertemporal Allocation of Resources, We Combine the NPV and Loanable Funds Diagrams

The crossover rate is the interest rate at which the two NPV [net present value] profiles cross. The wooden bridge has a higher NPV ranking when the interest rate is above the crossover rate, and the steel bridge has a higher NPV ranking when the interest rate is below the crossover rate. The two profiles cross because the steel bridge has a flatter profile than the wooden bridge. The steel bridge’s flatter NPV profile reflects that the net present value of the steel bridge is more interest rate sensitive than the net present value of the wooden bridge. When the interest rate changes by a given amount, the percentage change in the net present value of the steel bridge is greater than the percentage change in the net present value of the wooden bridge. In general, long-term projects are more interest rate sensitive than short-term projects. 

The interest rate regulates the intertemporal allocation of resources in the present value approach to economic calculation. To demonstrate, Figure 3 combines the NPV diagram and the loanable funds diagram. In Figure 3, the interest rate determined in the loanable funds market is greater than the crossover rate, so the wooden bridge has a higher NPV ranking. In this case the investor will allocate resources to the wooden bridge. 

Now suppose there is a change in consumer preferences so that consumers save more and consume less. The increase in the supply of savings causes the supply of loanable funds curve to shift to the right, from S to S′. The increase in saving reduces the interest rate and increases the amount of investment. 

Figure 4 shows that the increase in saving by consumers changes the investor’s NPV rankings. At the lower interest rate the NPV rankings tell the investor to allocate resources to the steel bridge. . . . 

Figure 4 shows how the interest rate coordinates the actions of consumers, savers, and investors by adjusting investors’ NPV rankings to reflect changes in the saving behavior of consumers.

—Edward W. Fuller, “The Marginal Efficiency of Capital,” Quarterly Journal of Austrian Economics 16, no. 4 (Winter 2013): 386-388.

Socialist Economists Erroneously Assume Various Forms of Knowledge to be Given and Display an Excessive Preoccupation with Stationary Equilibrium

In response to socialists who proposed that central planning required only that the planners solve the appropriate set of Walrasian equations, Hayek described the proposal as “humanly impracticable and impossible” and characterized its proponents as having failed to perceive the real nature of the problem. Socialist economists erroneously assumed various forms of knowledge to be “given” when in reality such knowledge is only discovered by people engaged in the competitive process. Moreover, much knowledge is dispersed and specific to time and place, and much knowledge is not transmissible but tacit, pertaining not so much to “what is” as to “how to.” Socialist economists displayed an “excessive preoccupation with the conditions of a hypothetical state of stationary equilibrium,” but actual economies are dynamic, undergoing constant change. Aiming to abolish profits, the socialists overlooked the essential role of profits as an equilibrating force. “To assume that it is possible to create conditions of full competition without making those who are responsible for the decisions pay for their mistakes seems to be pure illusion.”

—Robert Higgs, review of The Collected Works of F. A. Hayek, vol. 10, Socialism and War: Essays, Documents, Reviews, by F. A. Hayek, Quarterly Journal of Austrian Economics 1, no. 1 (Spring 1998): 82.

For Mises, Monetary Equilibrium, Like Equilibrium in General, Happens at the INDIVIDUAL Level

Mises’s individualist conception of equilibrium stands in stark contrast to Wicksell’s reliance on broad measures of macroeconomic aggregates. For Mises, the only equilibrium concept that applies to the real world is the plain state of rest. The plain state of rest is a strictly individual condition that is attained after each successful market transaction, when a particular want is fulfilled. It occurs repeatedly during the course of market operations as actors fulfill specific wants, then disappears as market conditions change and new wants are pursued. Individual states of equilibrium, or rest, can only be meaningfully aggregated up to the level of market clearing. That is, markets clear when all participants achieve a plain state of rest. Of course, this aggregate state disappears as quickly as do the individual states. Equilibrium in any broader sense is a useful concept only as an aid to understanding the goal of the market process: if the goal of action is the satisfaction of human wants, then action would cease only when all wants are fulfilled. This final state of rest is an unattainable condition since every change in economic conditions changes the nature of this state. It is a target constantly in flux, always aimed at but never hit.

For Mises, then, monetary equilibrium, like equilibrium in general, happens at the individual level. Each actor wants to keep a cash balance on hand for future transactions, both planned and contingent. This desired cash balance constitutes the individual’s money demand and is based on that individual’s subjective valuation of holding money as compared to their valuation of obtaining more goods or services with that money. The amount of money the individual actually has on hand constitutes his supply of money. Through their spending behavior, individuals will attempt to equate their desired and actual cash holdings.

—Kenneth A. Zahringer, “Monetary Disequilibrium Theory and Business Cycles: An Austrian Critique,” Quarterly Journal of Austrian Economics 15, no. 3 (Fall 2012): 309-310.

New Keynesian Views on Monetary Theory and Policy Are More Fallacious Than Those of Their Predecessors

The essential fallacy of John Maynard Keynes and his early disciples was to cultivate the monetary equivalent of alchemy. They believed that paper money was a suitable means to alleviate the fundamental economic problem of scarcity. The printing press was, at any rate under certain plausible conditions of duress, a substitute for hard work and savings and cutting prices. 

The self-styled new Keynesians have not at all abandoned this fallacy and they therefore do not differ in any essential respect from the old Keynesians, in spite of the pains they take to distinguish themselves from the latter. The new Keynesian recommendation for monetary policy is to “stabilize the growth of aggregate demand.” In plain language this means that the monetary authorities should never stop flooding the economy with paper money. Recognizably, this is the core tenet of the old Keynesian monetary program, which in itself had been nothing but even older fallacies clothed in the new language of aggregate analysis. 

In many respects, new Keynesian views on monetary theory and policy seem to be even more fallacious than those of their predecessors. Whereas Keynes and his immediate followers were still trained in the old-fashioned art of economic reasoning, the new Keynesians are macro economic purebreds. Their expertise lies more or less exclusively in the field of modeling. As with the macroeconomics profession in general, they are devoted to a positivistic methodology, putting all their energies into modeling quantitative relationships among things that are the result of human action, rather than into the analysis of human action itself. Not surprisingly, therefore, their “science” of the economy resembles a hotchpotch of educated guesswork, conventions, and fictions, all designed to make the problems under consideration amenable to mathematical treatment. 

—Jörg Guido Hülsmann, “New Keynesian Monetary Views: A Comment,” Quarterly Journal of Austrian Economics 6, no. 4 (Winter 2003): 73.

Irresponsible Monetary Policy Eventually Leads to an Increase in the Natural Rate of Unemployment

As Bellante and Garrison (1988) remind us, Friedman acknowledges that irresponsible monetary policy would eventually lead to an increase in the natural rate of unemployment. Two of Friedman’s papers (1976 and 1977) suggested the potential existence of a positively sloped Phillips curve. But in neither case did Friedman reconsider his model of dynamic monetary theory in light of his empirical work. 

In his Nobel lecture, Friedman acknowledged that additional research was needed to resolve the inconsistency between the monetarist Phillips curve and empirical data. He anticipated that this “third stage” of the research into the relationship between inflation and unemployment would only be successful if a way was found to incorporate political factors:

In recent years, higher inflation has often been accompanied by higher not lower unemployment, especially for periods of several years in length. A simple statistical Phillips curve for such periods seems to be positively sloped, not vertical. The third stage is directed at accommodating this apparent empirical phenomenon. To do so, I suspect that it will have to include in the analysis the interdependence of economic experience and political developments. It will have to treat at least some political phenomena not as independent variables—as exogenous variables in econometric jargon—but as themselves determined by economic events—as endogenous variables [. . .]. The third stage will, I believe, be greatly influenced by a third major development—the application of economic analysis to political behavior, a field in which pioneering work has also been done by Stigler and Becker as well as by Kenneth Arrow, Duncan Black, Anthony Downs, James Buchanan, Gordon Tullock, and others. (1977, p. 470)

In my doctoral thesis (Ravier, 2010), I called this “Friedman’s dilemma” because Friedman observed an empirical reality his own analytical framework was unable to explain. Friedman observes a positively sloped Phillips curve and a long-term effect of monetary stimulus which is not neutral in real terms. Both are inconsistent with his own theories. Instead he provides evidence confirming the work of Robert Lucas (1973) and, more recently, William Niskanen (2002). Robert Mulligan (2011) has demonstrated the connection between Niskanen’s article and Austrian business cycle theory.

—Adrián O. Ravier, “Dynamic Monetary Theory and the Phillips Curve with a Positive Slope,” Quarterly Journal of Austrian Economics 16, no. 2 (Summer 2013): 172-173.

De-Homogenizing Mises and Hayek: Hayek Favors the Productivity Explanation of Interest Instead of the Fetter-Mises Subjectivist Theory

A major reason for the neglect of this model is that in the United States, where the Austrian School experienced a renaissance in the second half of the twentieth century, the scholars adopted the Fetter-Mises subjectivist theory of interest instead of a productivity theory. The time preference theory of interest was endorsed by Rothbard ([1962] 2009), Garrison (1979), Kirzner (1993), and other authors (see Pellengahr 1996). Hayek (1941), on the other hand, very explicitly chose the productivity explanation of interest, even though he thought that time preference could also play a (minor) role in the determination of interest.³¹ As a result, his model—interpreted by Hayek as a validation of the productivity theory of interest—was largely overlooked.

__________

³¹ “Of the two branches of the Böhm-Bawerkian school, that which stressed the productivity element almost to the exclusion of time preference, the branch whose chief representative is K. Wicksell, was essentially right, as against the branch represented by Professors F. A. Fetter and I. Fisher, who stressed time preference as the exclusive factor and an at least equally important factor respectively.” (Hayek 1941, 420)

—Renaud Fillieule, “The Macroeconomic Models of the Austrian School: A History and Comparative Analysis,” Quarterly Journal of Austrian Economics 22, no. 4 (Winter 2019): 558-559.

During the Reign of Terror, Ceilings on Grain Prices Were Ridiculously Low and Enforced by the Guillotine

As with many hyperinflationary episodes, the French government attempted to implement price and exchange controls. In 1793, an exchange control known as “the Law of the Maximum” was enforced, decreeing that “any person selling gold or silver coin, or making any difference in any transaction between paper and specie, should be imprisoned in irons for six years; that anyone who refused to accept payment in assignats, or accepted assignats at a discount, should pay a fine of six thousand francs and suffer imprisonment for twenty years in irons” (Hamilton, 1977, p. 277). Hamilton (1977) also comments on the failure of the price controls during the French episode, and he observes that during the Reign of Terror (1793–1794), ceilings on grain prices were ridiculously low and effectively enforced by ruthless use of the guillotine. Although sales above the price ceilings seldom occurred, the authoritarian regime failed miserably in its efforts to force holders of grain to sell.

—Jayson Coomer and Thomas Gstraunthaler, “The Hyperinflation in Zimbabwe,” Quarterly Journal of Austrian Economics 14, no. 3 (Fall 2011): 336-337.

Fashioned after Communist Movements in Cuba and the USSR, Zimbabwe’s Government Retained Its Revolutionary Flavor

Ideological governments tend to fight what is beyond their control, in particular the free market. Once policies are implemented that interfere with these forces, the market will continue to react. More often than not, the forces of the free market do not simply cease their existence, but rather find different ways to manifest themselves.

Zimbabwe’s government had sprung from guerrilla roots and its ideology still retained its revolutionary flavor. Fashioned after the communist movements in Cuba and the Soviet Union, the military influence in politics was huge. Communist ideas were behind the attempt to restore a “balance” of power and economic wealth, away from the white colonial minority, and toward the indigenous majority. 

The forceful dispossession of the landowners followed a similar logic as so many dispossession waves before. The move toward indigenization is similar to the Communist nationalization in the Soviet Union. In mid-1918, the Communists nationalized all large factories, banned private trade and appropriated goods and resources from the rich and the middle-class (Fischer, 1994). The dispossession was depicted as a necessary act to achieve a greater good in society. Yet, it was also the beginning of the Soviet Union’s hyperinflation. . . . 

High inflation can also be used as a tool to speed up the achievement of a perceived equality of the “classes.” Lenin is said to have looked to the debauching of a country’s currency as the best way to the overthrow capitalism (Keynes, 1920). Through a prolonged period of inflation, a government can confiscate the wealth of its citizens. This potential to use money creation to enforce a communist ideology was seen in the Soviet Union hyperinflation. “The new regime had a clear desire for rapid inflation to wipe out the middle classes and speed the revolutionary cause” (Capie, 1986, p. 128). The drastic depreciation of the rouble was justified by the Soviets as a method of expropriating the bourgeoisie (Maier, 1978). A similar event happened in Hungary, when the Soviets overruled the Hungarian Central Bank’s objection to the vast numbers of Treasury Bills being issued (Capie, 1986).

—Jayson Coomer and Thomas Gstraunthaler, “The Hyperinflation in Zimbabwe,” Quarterly Journal of Austrian Economics 14, no. 3 (Fall 2011): 333-334.

Axel Leijonhufvud Says the Subprime Crisis of 2008 More Closely Fits the ABCT than the Keynesian Framework

Axel Leijonhufvud, an economist known internationally for his work on the literature of John Maynard Keynes and Keynesianism, has suggested that the subprime crisis of 2008 more closely fits the Austrian business cycle theory of Ludwig von Mises and Friedrich Hayek, than the Keynesian framework.

In this paper, we provide evidence for that claim. More specifically, we assert the following: 

1. that the subprime crisis, or the “housing-bubble” is not an isolated incident. Rather, it is one of a number of related events whose origins can be found in the monetary policy that the Fed has adopted at least since 1980;
2. that when we concentrate on the most recent cycle, (Krugman, 2002), we find that the Fed intentionally replaced the dot-com bubble with a housing bubble, expanding the money supply at a rate of 10 percent (measured by M2), and reducing real interest rates too low for too long; 
3.  that Greenspan-Bernanke, on behalf of the Fed, asserted, without foundation and contrary to the evidence, that the crisis was not rooted in the politics of the institution they lead, but was rather a global phenomenon, a “savings glut,” which reduced the long-term interest rate naturally; 
4.  that the popular explanation that blames the deregulation of markets as a cause of the crisis, is also unfounded. In fact, the banking system is one of the most regulated sectors in the U.S. economy. It was, in fact, the excessive regulation of the system, which channeled the easy money policy of the Fed into real estate, thus distorting the physical capital structure of the economy;
5.  that the boom we have seen in the housing sector started between 2001 and 2004, and could only have persisted as long as the Fed was able and willing to keep interest rates low, a policy which risks the precipitation of general price inflation. In the face of this threat, the Fed finally raised interest rates, bowing to market pressure as the demand for loanable funds increased. This produced the inevitable deflating of the bubble and the onset of crisis and recession, not only in the real-estate sector, but also in the banking-sector which supported it during the boom;  
6.  that the long-term adjustment process involving as it does adjusting fundamental macroeconomic variables to underlying economic realities has real and enduring consequences. These effects are not “neutral.” Real capital value has been destroyed in the process;
7. that while there is a consensus among economists about expanding the monetary-base as the best “emergency strategy” when facing a possible secondary contraction, Bernanke could have avoided micro-engineering and the favoritism and moral hazard that it implies, and opted for open market operations, rather than the selective rescue of some large companies (those that were “too big to fail”); 
8. that accompanying the Fed’s monetary policy, the U.S. Treasury followed an expansionary fiscal policy in an effort to boost employment and thus mitigate recessionary expectations. But the fiscal deficits that the federal government and state-governments has and are accumulating have not delivered the promised employment increases. The fiscal crisis they have produced portend painful, but inevitable, adjustments—expansionary fiscal policies cannot continue and will have to be reversed. We conclude that it should be no surprise if the U.S. economy should fall into a new cycle in the coming years, even though economics does not provides the tools to predict the precise timing of it.

—Adrian Ravier and Peter Lewin, “The Subprime Crisis,” Quarterly Journal of Austrian Economics 15, no. 1 (Spring 2012): 46-47.

Alfred Marshall Attacks the “Perfect Knowledge Assumption,” BUT Sees Horizontal Demand Curves as a “Ruling Fact” in the Economy

Alfred Marshall, on this as in on so many other issues, was an eclectic tangle of confusions and inconsistencies, varying in his editions of his Principles (1st ed., 1890). There were two basic and conflicting strains in Marshall here. On the one hand, he had a position close to the classicists: considering free competition as a broad relationship holding throughout the market, and not feeling the need to make the definition of competition narrow and rigorous. In fact, he expressly attacked the doctrine of “perfect competition” in his eighth edition, and said that a negatively sloping demand curve to a firm was compatible with competition. The term “monopoly” was used but not precisely defined, but presumably referred to a single seller of a commodity.

On the “perfect knowledge” assumption in perfect competition, Marshall was properly caustic: 

we do not assume that competition is perfect. Perfect competition requires a perfect knowledge of the state of the market.... [I]t would be an altogether unreasonable assumption to make.... The older economists, in constant contact as they were with the actual facts of business life, must have known this well enough; but, partly because the term “free competition” had become almost a catchword... they often seemed to imply that they did assume this perfect knowledge.

On the other hand, Marshall, too, was influenced by mathematical economists to some degree, and therefore by Cournot. In the third edition of his Principles, he introduced the Cournot idea that the horizontal demand curve for the firm was the ruling fact in the economy, and that the falling demand curve was the exception. Here was the disastrous concession that perfect competition, or pure competition (the horizontal demand curve), while perhaps not necessary to the whole economy or even ideal, was the ruling case in the economy. This position appeared particularly in Marshall’s famous Mathematical Appendix, which was heavily influenced by Cournot.

—Murray N. Rothbard, “Competition and the Economists,” Quarterly Journal of Austrian Economics 15, no. 4 (Winter 2012): 403-404.

The French Mathematician Antoine Augustin Cournot Founded Modern Monopoly and Perfect-Competition Theories

Meanwhile, unheralded and unrecognized at the time, the French mathematician Augustin Cournot, founded not only mathematical economics but also modern monopoly and perfect-competition theories, in his Principes in 1838. To make things easy for using the calculus in dealing with profits, revenues, and costs of a business firm, Cournot defined competition as that situation where price does not vary with the quantity of the good produced: i.e., where the demand curve for the firm is horizontal, or “perfectly elastic.” Not only did Cournot thus found the basic axiom of perfect competition theory, he also believed that such a condition only obtains where the number of firms is large, and that when firms are fewer, “oligopoly” ensues. Cournot worked out a theory of “duopoly.”

Thus, with Cournot, the seeds of modern perfect-competition and monopolistic-competition theories were already set, as well as modern mathematical economics: “competition” only occurs when the demand curve for the firm is horizontal; this takes place only when the number of firms in the industry is very large; a smaller number leads to “monopolistic” situations of “oligopoly,” etc. Of course, a single firm in an industry, where the demand curve is of course falling, Cournot defined as a “monopoly.”

—Murray N. Rothbard, “Competition and the Economists,” Quarterly Journal of Austrian Economics 15, no. 4 (Winter 2012): 400-401.

CAPM’s Assumptions Supplant Heterogeneous Human Persons with an Army of Homogeneous Robots

The current mainstream in investment appraisal relies on input parameters within the income approach that are much different from what investment theory requires. It is based upon neoclassical finance theory and neglects the crucial personal perspective in favor of a questionable “objective” market perspective (Matschke, and Brösel, 2013, pp. 26–27). Though the prevalent mainstream discounted cash flow (DCF) methods are also based upon the income approach, they are inadequate as a decision tool (e.g., Rapp, 2014b, p. 1067). The main reason for this diagnosis is the application of finance-theory based models within current DCF methods (Hering, 2014, p. 263).

In these methods, the discount rate is usually, at least partly, assessed using the capital asset pricing model (CAPM) (Koller, Goedhart, and Wessels, 2010, p. 234). Instead of considering the essential personal endogenous marginal interest rate, the CAPM aims at the determination and application of an “objective” discount rate (Hering, 2015, p. 307). In order to measure an, at least hypothetically, objective discount rate, the CAPM must rely upon several restrictive assumptions (e.g., Perridon, Steiner, and Rathgeber, 2012, p. 546, Hering, 2015, p. 297). These include a perfect capital market (which includes the existence of a single market interest rate for both investments and lending; unlimited access to lending independent of debt ratio, credit-worthiness, credit amount and time pattern; symmetric distribution of information; and the absence of taxes as well as transaction costs) and economic agents with both homogeneous expectations and a standardized risk appetite (µ-σ-principle). Basically, CAPM’s assumptions supplant heterogeneous human persons with an army of homogeneous robots. Because the subjective values of homogeneous robots coincide, the model can generate a (hypothetical) single objective market value (Matschke, and Brösel, 2013, p. 27). The uniformity of economic agents in the CAPM leads finally to the market portfolio which includes every risky asset and which is held by every single investor. In other words, in the CAPM world, everybody owns everything (Hering, 2015, pp. 298–299). The sole ownership of any company is, by definition, impossible. Thus, the purchase or sale of an entire company is excluded as well. Nevertheless, the CAPM is applied for the investment appraisal of entire businesses in preparation of merger and acquisition decisions all over the world every single day.

—Jeffrey M. Herbener and David J. Rapp, “Toward a Subjective Approach to Investment Appraisal in Light of Austrian Value Theory,” Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 20-22.

Irving Fisher Made One of the First Attempts to Dismiss the Business Cycle as an Independent Economic Concept

In 1891, Fisher wrote the first dissertation in economics at Yale University, Mathematical Investigations in the Theory of Value and Prices (1892). It was directed in part by members of the Yale mathematics faculty and became a true landmark in the development of mathematical economics. The use of mathematics in economics spread in the first half of the twentieth century and came to dominate the economics profession in the second half of the century. It now enjoys near complete supremacy in graduate programs and in the leading academic journals devoted to economics. Likewise, the general equilibrium theorizing from his dissertation has also become the stock in trade of mainstream economics.

Fisher (1913) also changed how the economics profession viewed the quantity theory of money. He converted the classical view of the quantity theory from a theory into a mechanism that could (and should) be manipulated in order to stabilize the value of money. He presented his views in The Purchasing Power of Money, where he introduced the concept of a “compensated dollar.” He wanted to change our notion of the dollar from one of a coin with a constant weight of gold to one of a currency that had constant purchasing power. Fisher is therefore credited with forming the foundations of monetarism and the monetary policy rules used today by central bankers.

Fisher’s development of index numbers as a method of measuring the purchasing power of the dollar is also a landmark in the history of modem economic orthodoxy. His policy of price-level stabilization requires the central bank’s monetary policy to target and stabilize a price index. Fisher (1927) was one of the first to define and calculate index numbers and he even began to publish a weekly wholesale price index in the early 1920s. His foundational work The Making of Index Numbers showed the basis of how central bankers could conduct and review monetary policy. Modern mainstream economists today would view any other approach to monetary policy as unscientific and they are in agreement with Fisher that price-level inflation and deflation are inherently bad things, and that the value of the dollar (as measured by price indexes) should be stabilized like physical measurements such as the meter or kilogram. Fisher (1925) can also be credited with one of the first attempts to dismiss the business cycle as an independent economic concept.⁷ He even discovered what was to become the famous Phillips curve (which depicts an inverse relationship between inflation and unemployment) decades prior to A. W. Phillips. In this light, modem macroeconomics can be seen as nothing but a thick layer of dust on the foundations laid by Fisher.

⁷ See Fisher (1925) where he attempts to empirically show that it is the instability of the purchasing power of the dollar that is the problem, not the business cycle per se. Mainstream economists also dismiss the idea of the business cycle and that it is really just “shocks” and “real factors” that cause changes in the economy. See for example Milton Friedman's (1993) plucking model.

—Mark Thornton, “The Great Depression: Mises vs. Fisher,” Quarterly Journal of Austrian Economics 11, no. 3 (Fall 2008): 233, 233n7.

In 1928, Mises Published a Book Predicting that Fisher’s Approach Would Lead to an Economic Crisis and Collapse

Ludwig von Mises established the foundations of modern Austrian economics while Irving Fisher established the foundations of modern mainstream macroeconomics and central bank policy. Fisher helped create and was a proponent of mathematical economics, statistics and index numbers, and a monetary policy that “stabilized” the value of the dollar. Fisher claimed that his scientific approach established a new era of prosperity during the 1920s. Mises published a book in 1928 that critiqued Fisher’s approach and predicted that it would lead to an economic crisis and collapse. Before the stock market crash in 1929 Fisher proclaimed a perpetual prosperity for the economy and continued to recommend investing in stocks long after the market had collapsed. In this important case study, Mises passed the “market test” while Fisher lost his personal fortune during an economic crisis that his economics help create.

—Mark Thornton, “The Great Depression: Mises vs. Fisher,” abstract, Quarterly Journal of Austrian Economics 11, no. 3 (Fall 2008): 230.

Capital-Based Growth Is Fundamental to All Austrian Macroeconomics

One of the distinguishing characteristics of the Austrian school throughout the development of modern macroeconomics was its structure of production framework and capital theory. Building on Menger’s (2007 [1871]) insights regarding the categorization of goods as “higher order” or “lower order,” Böhm-Bawerk (1930 [1889]) presented a structure of production theory based upon the roundaboutness of production processes and recognized time preference as a factor in determining the interest rate and economic growth. Mises (2009 [1912]) used these insights among others to sketch a capital and monetary based business cycle theory and later contributed to the pure-time-preference theory of interest (Mises, 2008 [1949]). Hayek (2008 [1931]) made notable contributions to capital and business cycle theory, including a graphical representation of the structure of production that could show both sustainable and unsustainable growth, which he subsequently attempted to further improve (Hayek, 2012 [1941]). Rothbard (2009 [1962]) synthesized this entire system traceable to Böhm-Bawerk through his “development of a capital and interest theory that integrated the temporal production-structure analysis of Knut Wicksell and [F.A] Hayek with the pure-time-preference theory expounded by Frank A. Fetter and Ludwig von Mises” (Salerno, 2009, p. xxvii). Using the ideas of earlier Austrian theorists as well as adding his own contributions, Rothbard presented the relationship between the interest rate and the proportion between consumption and investment in the clearest and most logically deduced manner as well as the capital-based growth that underlies Austrian macroeconomics.

The basic growth scenario entails a fall in time preference, which is represented by a decrease in consumption spending and an increase in investment spending. The additional investment funds are spent on higher order goods, and increase the number of production stages to reflect the lower natural rate of interest. The opposite occurs for an increase in time preferences. Graphically, the change in time preference is generally visualized as a movement in the supply curve along a constant demand curve in the loanable funds market, which implies a similar shift in the overall time market (Skousen, 2007, p. 233; Garrison, 2006, p. 62). This capital-based growth is fundamental to all current Austrian macroeconomics since it provides the basis for the generalizations made about the capital structure and time preference, mainly, that the proportion of present consumption spending to investment (future consumption) spending is systematically related to the interest rate through time preference. In other words, changes in time preferences are embodied in changes in both as “the time preferences of the individuals on the market determine simultaneously and by themselves both the market equilibrium interest rate and the proportions between consumption and savings (individual and aggregate).” (Rothbard, 2009, p. 400).

—Patrick Newman, “Rothbard's Time Market and the Demand for Present Goods,” Quarterly Journal of Austrian Economics 17, no. 1 (Spring 2014): 47-48.

The Circular-Flow Diagram's Greatest Problems Are Its Circularity and Its Lack of Acting Entrepreneurs

Traditional economic analysis frequently begins with a circular-flow diagram showing an on-going relationship between firms and households, connected through markets for goods and services on the one hand and markets for factors of production on the other hand. The origins of the circular-flow diagram have been attributed to Frank Knight, who first published the modern interpretation, although different versions of the circular flow have appeared in many economic works (Patinkin 1973).

The circular-flow approach is decidedly Neoclassical, and suffers from many problems which traditional Austrians would notice. The circular-flow diagram’s greatest problem is, in fact, its circularity. While real-world economic analysis has a beginning, an ending, and ever-changing processes, the circular-flow diagram has no beginning or ending. It is drawn as though entire macroeconomies sprang into existence from whole cloth. While the circular flow appears to be dynamic, it allows no room for change on any margin: consumer preference, production technique, or availability of factors of production.

The most important actor in the economic process for Austrians, and an element crucial to every single real-world market—the entrepreneur—is missing from the circular flow didactic. It is the entrepreneur who

• judges future expected consumer good prices,
• anticipates future market conditions,
• seeks new production techniques, and
• delivers the product to the consumer.

Without a role for the entrepreneur, the circular-flow diagram loses all touch with reality.

—Barry Dean Simpson and Scott A. Kjar, “Circular Flow, Austrian Price Theory, and Social Appraisement,” Quarterly Journal of Austrian Economics 8, no. 4 (Winter 2005): 3-4.

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.

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.