Only Free Banking Would Have Rendered the Market Economy Secure Against Crises and Depressions

Mises blamed unwarranted credit expansion on political pressures for cheap money that the central bank failed to resist. As an institutional reform to avoid the problem he favored free banking, a monetary system without a  central bank, although he acknowledged that the spread of central banking throughout Europe in previous decades had made the choice between free banking and central banking one of those “questions that have long been regarded as closed.” Exemplified by Scotland, Sweden, Canada, Switzerland, and other countries in the periods before their central banks were created, free banking meant a system in which decentralized and competitive commercial banks issue the paper currency, tied down by a contractual obligation to redeem their notes for gold or silver coin.

Advocates of free banking argued that competition would prevent all the banks from colluding to expand in concert, and interbank redemption of excess notes or deposits would restrain any smaller set of banks from overexpanding. International redemption would restrain the system as a whole. In his later treatise Human Action Mises wrote along these lines:

Free banking is the only method for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all the information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular — one is tempted to say normal — feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.

—Lawrence H. White, The Clash of Economic Ideas: The Great Policy Debates and Experiments of the Last Hundred Years (New York: Cambridge University Press, 2012), 74-75.

As a Major Cause of the Great Contraction of 1929-1933, the “Real Bills Doctrine” (Not Gold) Is the “Smoking Gun”

How could such a disaster have happened? What caused the Great Contraction of 1929–1933, and why were Federal Reserve policymakers unable to respond effectively to it? Many observers—both at the time and to this day—have blamed the gold standard for the contraction and the depression that followed it. The gold standard’s many critics regard it as an antiquated institution that fatally tied the hands of authorities in the 1930s and prevented them from saving the U.S. economy from disaster.

In reality, however, no account of events in the United States in the 1920s and 1930s could be further from the truth. A dispassionate observer could hardly imagine that a naturally occurring gold money, with a long history of disciplined and orderly acceptance and operation behind it, could suddenly in the few years between 1929 and 1933 have initiated and prolonged a worldwide depression of such magnitude. It simply does not make sense. For one thing, the operational gold standard, according to which the movement of gold into and out of the United States automatically determined the economy’s stock of common money (i.e., banknotes and deposits), ended forever when the United States became a belligerent in World War I. What replaced it was a pseudo–gold standard managed by the Federal Reserve System (the Fed). That institution’s founding legislation, the Federal Reserve Act of 1913, required Federal Reserve banks to maintain minimum gold reserves against their issues of Federal Reserve note currency and their holdings of reserve balances for member banks. Indeed, during the years of the Great Contraction, Federal Reserve officials frequently suggested that they were constrained by the “limited” quantity of monetary gold reserves available.

This view, however, ignores the fact that the Federal Reserve Act gave the Fed Board of Governors complete statutory power to abolish all gold reserve requirements in the event of an emergency. That is, all the Fed banks’ gold reserves, both “required” and “excess,” were available for any necessary redemptions. In addition, no shortage of monetary gold appeared in Fed banks during the Great Contraction. By mid-1931, Federal Reserve banks had more than double the legally required gold reserves. As late as early March 1933, Federal Reserve banks collectively still held more gold than they had had in 1929. And although that month witnessed a run on gold that ultimately precipitated the National Bank Holiday, only the New York Federal Reserve Bank was in danger of breaching its gold reserve requirement. The Federal Reserve System as a whole still had a gold surplus of $100 billion.

Had the Federal Reserve System wanted to, it could easily have followed Walter Bagehot’s famous rules for last-resort lending throughout the Great Contraction period, using all of its gold if necessary to satisfy any panic-inspired demand for reserves. The monetary contraction and banking collapse that plunged the United States into depression and eventually led to the Bank Holiday need never have happened. What explains the Fed’s inaction? What could have made the 12 Federal Reserve banks and the Fed Board in Washington completely inactive as the financial system fell apart around them? Answering that question is the chief concern of this book. Our contention is that a variant of a now-forgotten monetary theory—most commonly known as the “Real Bills Doctrine”—played a central, even determining role in bringing this economic disaster to pass. It is the “smoking gun” researchers have been seeking—and overlooking—in their efforts to identify the Great Depression’s major cause.

—Thomas M. Humphrey and Richard H. Timberlake, introduction to Gold, the Real Bills Doctrine, and the Fed: Sources of Monetary Disorder, 1922-1938 (Washington, DC: Cato Institute, 2019), e-book.

The Hayek-Robbins Austrian Theory of the Business Cycle Did NOT Prescribe a Policy of “Liquidationism” to Solve the Great Depression

DeLong's thesis that the Hoover administration and the Federal Reserve were following Austrian advice thus coincides with Friedman’s judgment that the Austrian advice did harm. Both suggest that “do-nothing” policy prescriptions by Hayek and Robbins contributed to deepening the Great Depression in the United States.

But is this an accurate account of Hayek’s and Robbins’ actual monetary and fiscal policy advice during the early years of the Great Depression? Is it an accurate account of the policies of the Hoover administration, of the Federal Reserve System, and of what influenced them? A critical examination finds DeLong’s history unpersuasive on four key points.

1. The Hayek-Robbins (“Austrian”) theory of the business cycle did not in fact prescribe a monetary policy of “liquidationism” in the sense of doing nothing to prevent a sharp deflation. Hayek and Robbins did question the wisdom of reinflating the price level after it had fallen from what they regarded as an unsustainable level (given a fixed gold parity) to a sustainable level. They did denounce, as counterproductive, attempts to bring prosperity through cheap credit. But such warnings against what they regarded as monetary over-expansion did not imply indifference to severe income contraction driven by a shrinking money stock and falling velocity. Hayek’s theory viewed the recession as an unavoidable period of allocative corrections, following an unsustainable boom period driven by credit expansion and characterized by distorted relative prices. General price and income deflation driven by monetary contraction was neither necessary nor desirable for those corrections. Hayek’s monetary policy norm in fact prescribed stabilization of nominal income rather than passivity in the face of its contraction. The germ of truth in Friedman’s and DeLong’s indictments, however, is that Hayek and Robbins themselves failed to push this prescription in the early 1930s when it mattered most.
2. With respect to fiscal policy, the Austrian business cycle theory was silent. Hayek and Robbins did oppose make-work public programs, but they opposed them because they believed that the programs would misdirect scarce resources, not because the programs were financed by public-sector borrowing.
3. There is no evidence that either Hoover or Mellon, or any “liquidationist” in the Federal Reserve System, drew policy inspiration from Hayek or Robbins. Given that Hayek’s theory was unknown to English-language economists before he gave the lectures published as Prices and Production in 1931, it would be surprising to find that Hayek had influenced the U.S. policy debate in 1930. Robbins’ writings on the Depression came even later. Rather than following Hayek or Robbins, the Fed’s decision makers were following a variant of the real bills doctrine, as Richard H. Timberlake, Jr. (1993, pp. 259-83; 2007, pp. 339-43), David C. Wheelock (1991, p. 111), Allan H. Meltzer (2003, pp. 76, 138-139, 263-66, 322), and David Laidler (2003a, pp. 1259-63) have emphasized. 
• The Austrian and real-bills views should not be conflated. If they were, as Laidler (2003a, p. 1263, n. 11) puts it, “Apparently parallel strands in the literature,” then such an appearance was misleading. In key respects the two views were diametrically opposed. It may be true, as Laidler (2003b, p. 26) argues, that by offering their own non-expansionist policy advice in the early 1930s “the Austrians . . . lent considerable academic respectability to similar views, based on the so-called needs of trade or real bills doctrine, which at that time had wide currency in banking circles in general, and at the Federal Reserve Board in particular.” Nonetheless, the Austrian and real-bills views were analytically quite distinct, and the Austrians were not the source of the Fed’s thinking.
4. Herbert Hoover explicitly rejected “liquidationist” doctrine in both word and deed. Hoover’s claim that Mellon advocated liquidationism in cabinet meetings lacks corroboration from Mellon’s public statements.

—Lawrence H. White, “Did Hayek and Robbins Deepen the Great Depression?” Journal of Money, Credit and Banking 40, no. 4 (June 2008): 753-754.

The Dream of Economists in the 1920s Was to Stabilize the Buying Power of the Monetary Units Using “Managed Currencies”

In the decades after the First World War, the goals assigned to monetary central planning changed, but the instrument for their application remained the same — central bank management of the money supply. As we have seen, Yale University economist Irving Fisher advocated the stabilization of the price level. As Fisher stated in The Money Illusion (1928),

To stabilize the buying power of the monetary units has long been the dream of economists. . . . And since the volume of circulating credit is controllable and controlled [through the Federal Reserve central bank], we have already a managed currency in spite of ourselves. If we insure scientific management in place of hit-and-miss management we shall thereby attain stabilization.

John Maynard Keynes argued in his Tract on Monetary Reform (1923), “The war has affected a great change. Gold itself has become a ‘managed’ currency. . . . All of us from the Governor of the Bank of England downwards are now primarily interested in preserving the stability of business, prices and employment.” The goal of monetary central planning, in Keynes’s view, as he articulated it in the 1930s, was for monetary policy to support and facilitate government “aggregate demand management” for manipulating the economy-wide levels of employment and output.

—Richard M. Ebeling, “The Gold Standard as Government-Managed Money,” in Monetary Central Planning and the State (Fairfax, VA: Future of Freedom Foundation, 2015), Kindle e-book.

Because Money Serves as the Link Connecting Savings and Investment Decisions, There Could Arise Imbalances in the Savings-Investment Process

In 1898, Wicksell published Interest and Prices. He adapted Böhm-Bawerk’s theory of capital and time-consuming processes of production and took it a step further. Wicksell explained that in actual markets, goods do not trade directly one for the other. Rather, money serves as the intermediary in all transactions, including the transfer of savings to potential borrowers and investors. Individuals save in the form of money income not spent on consumption. They then leave their money savings on deposit with banks, which serve as the financial intermediaries in the market’s intertemporal transactions.

Banks pool the money savings of numerous people and lend those savings to credit-worthy borrowers at the rates of interest that come to prevail in the market and that balance the supply of the savings with the investment demand for it. The borrowers then use the money savings to enter the market and demand the use of resources, capital, and labor by offering money prices for their purchase and hire. Thus, the decrease in the money demand and the lower prices for consumer goods due to savings — and the increased demand and the higher money prices for producer goods due to investment borrowing — act as the market’s method to shift and reallocate resources and labor from consumption purposes to capital-using production purposes.

But Wicksell pointed out that precisely because money served as the intermediary link in connecting savings decisions with investment decisions, there could result a peculiar and perverse imbalance in the savings-investment process. Suppose that the savings in the society was just sufficient to sustain the undertaking and completion of periods of production of one year in length. Now suppose that the government monetary authority in that society were to increase the amount of money available to the banks for lending purposes. To attract borrowers to take the additional lendable funds out of the market, the banks would lower the rates of interest at which they offered to lend to borrowers.

The lower market rates of interest due to the monetary expansion would raise the present value of investment projects with longer time-horizons until their completion. Now suppose that borrowers were consequently to undertake investment projects that involved a period of production of two years in length. Because of their increased money demands for resources and labor for two-year investment projects, some of the factors of production would be drawn away from one-year investment projects. As a result, at the end of the first year, fewer consumer goods would be available for sale to consumers. With fewer consumer goods on the market at the end of the first year, the prices of consumer goods would rise and consumers would have to cut back their purchases of consumer goods in the face of the higher prices. Consumers, Wicksell said, would be forced to save, i.e., they would have to consume less in the present and wait until the second year had passed and the two-year investment projects had been completed to have any greater supply of goods to buy and consume.

At the same time, the greater supply of money offered for resources and goods on the market would be tending to increase their prices and, as a consequence, the society would experience a general price inflation during this process. If the government monetary authority were to repeat its increase of the money supply time-period after time-period, there would be set in motion what Wicksell called an unending “cumulative process” of rising prices.

—Richard M. Ebeling, “The Austrian Theory of the Business Cycle,” in Monetary Central Planning and the State (Fairfax, VA: Future of Freedom Foundation, 2015), Kindle e-book.

The “Ex Post” Situation of “Forced Saving” Is the Discrepancy between Actual and Planned Saving, (I₁ — S₁)

A single concept dominates virtually all discussions of forced saving. Entrepreneurs have an increased command over the scarce resources as the result of an increase in the quantity of money, which enters the system as an increase in credit. The prices of capital goods are bid up, and the production of capital goods is stimulated. Factor incomes are bid up; eventually, the demand for consumption goods increases. But only by this process and in this sequence, do changes in the quantity of money affect prices. That these changes eventually affect all prices was not in dispute; the issue was the mechanism by which money affects prices.

Forced saving obviously refers to an ex post situation [ex post means based on what actually happened and not based on forecasts]. Consumers find that they must consume less than they had planned at each level of income. Consumer goods are not being produced at the rate at which consumers intend to consume them.

The schedules in figure 3.1 refer to planned magnitudes. Ex post, investment (I) = I₁ and saving (S) is equal in value to investment, I₁. Thus the forced saving is equal to the discrepancy between actual and planned saving (I₁ —S₁). Forced saving occurs during each period (in which the quantity of money increases) because of the nonneutral effects of the monetary disturbance. The assumption is that monetary expansion is primarily an increase in the amount of credit available to business.

—Gerald P. O’Driscoll Jr., Economics as a Coordination Problem: The Contributions of Friedrich A. Hayek, Studies in Economic Theory (Kansas City: Sheed Andrews and McMeel, 1977), 53-54.

The Coercive Machinery Is Represented by the GPU (Later KGB) in Russia, But by Credit Expansion of the Banking System in the West

For this it is necessary that some kind of coercion be exerted which releases the production of capital goods from the link with the community’s voluntary decisions to save, and forces the proportional shrinkage of the production of consumption goods above the level to which the community is prepared to submit voluntarily through its savings. This coercion may take place with the brutal overtness of Russia today under the rule of the Five-Year Plan which represents to the trade-cycle theorist a gigantic attempt with the aid of government authority to free the tempo and extent of investment from the limitations imposed by the rate of savings—consumption being ruthlessly held down by means of State force. This throws further light on the probability mentioned already that in Russia also the steepness of the investment curve will find its counterpart in the sharp descent of the curve of reaction, only with the difference that the reaction in Russia will assume other forms than in the capitalistic countries. It is in any case useful to realize that what is being carried out in Russia differs from the type of boom characterized by over-capitalization in the capitalist countries in method and extent only, and not in kind, and bears a likeness to it even so far that all warnings of inevitable reaction are thrown to the winds. In the capitalist economy the place of authoritarian force is taken by credit expansion.

As will be seen in the next section, the expansion of credit also involves “forced saving,” though of a totally different kind. The difference may perhaps be expressed by saying that in our economic system it is monetary “forced saving” which sets the wheels of over-investment in motion, while in Soviet Russia it is authoritarian “forced saving.” Whereas in Russia the coercive machinery is represented by the G.P.U. with its rifles and dungeons, in capitalism it is represented by the banking system with its cheques and overdrafts. This capitalistic machinery of credit expansion serves two purposes: in the first place, it provides the entrepreneur waiting to invest with the necessary additional credit and, in the second place, by raising profit expectations, it increases the desire to invest, of which the driving force is here, in contrast to the socialist State, governed by individual decisions based on profit expectations. This is, in fact, the way in which the process of cyclical movement regularly takes place in the capitalist world.

—Wilhelm Röpke, Crises and Cycles, ad. and rev. Vera C. Smith (London: William Hodge and Company, 1936), 107.

A Depression May Grow to Dimensions Out of Proportion to the Preceding Boom, Losing Its Readjustment Function, Degenerating into a “Secondary Depression”

The upshot of all that we have so far said is that the causation of the crisis and of the depression must be traced back to the mechanism of the boom. We understand now not only why the boom simply comes to a halt but also why it is usually followed by a painful process of contraction and liquidation. A satisfactory explanation of the boom implies, therefore, the explanation of the crisis as well. For this reason the theory of crises and cycles is essentially a theory of the boom. In the crisis, what has been sown during the boom has to be reaped; a readjustment of the disjointed economic system cannot be avoided. This is a point which must be emphasized strongly. But it is also a point which must not be driven too far. As the dramatic development of the present crisis abundantly proves, there is no denying the fact that the depression may, under certain circumstances, grow to dimensions quite out of proportion to the preceding boom, so that it loses more and more its function of readjustment and degenerates into a secondary depression void of any function whatsoever except to test the strength of the patience of the people in enduring a cumulative process of senseless and murderous economic destruction. Instead of restoring the economic equilibrium disrupted by the boom, the depression may lead, after a while, to a new disequilibrium which, caused by the process of the chronic depression itself, has nothing to do with the old set of disturbing factors. To explain this, a special theory of the depression becomes necessary. Its task is to describe how the original process of liquidation and adaptation in the primary depression comes to set in motion a cumulative process of recession, the conditions of disequilibrium being continuously reproduced on an ever-declining level of economic activity.

—Wilhelm Röpke, Crises and Cycles, ad. and rev. Vera C. Smith (London: William Hodge and Company, 1936), 119-120.

By “Secondary Deflation” We Mean that the Deflation Is INDUCED by the Maladjustment in the Structure of Production

The theory of the depression is not nearly so fully elaborated by the authors of the monetary over-investment school as the theory of the boom. The depression was originally conceived of by them as a process of adjustment of the structure of production, and was explained in non-monetary terms. During the boom, they argued, the process of production is unduly elongated. This elongation has accordingly to be removed and the structure of production has to be shortened or, alternatively, expenditure on consumers’ goods must be reduced (by retrenchment of wages and other incomes which are likely to be spent wholly or mainly on consumers’ goods) sufficiently to make the new structure of production possible. Workers are thrown out of work in the higher stages, and it takes time to absorb them in the lower stages of production. In modern times especially, with inflexible wage systems and the various other obstructions represented by all kinds of State intervention, this process of shifting labour and other means of production is drawn out much longer than is necessary for purely technological reasons.

This non-monetary explanation of the depression is, however, admittedly incomplete and unsatisfactory. The majority of the authors of the group under review were at first very reluctant to recognise that there is a cumulative process of contraction corresponding to the cumulative process of expansion. But eventually it was admitted that, in addition to the difficulties which must arise from the fact that the structure of production does not correspond to the flow of money (in other words, the disturbances which result from the deflection of the money stream from the higher to the lower stages of production), there must be a deflation—that is, a shrinkage in the aggregate flow of money. The difficulties which result from this general shrinkage in the flow of money are super-imposed on the disturbances involved in the necessary readjustment in the structure of production. Without assuming a general deflation, it is impossible to explain why the depression spreads to all stages and branches of industry, why it is not confined only to those industries which are over-developed and must therefore eventually contract (the higher stages), but extends also to those which are under-developed and must therefore eventually expand (the lower stages). It has become customary to speak of “secondary deflation,” by which it is intended to convey that the deflation does not come about independently, but is induced by the maladjustment in the structure of production which has led to the breakdown. Without the latter, it is believed, the deflation would not start at all.

—Gottfried Haberler, Prosperity and Depression: A Theoretical Analysis of Cyclical Movements, 3rd ed. (1943; repr., Lake Success, NY: United Nations, 1946), 57-58.

Lachmann Worked on Secondary Depressions or the Process of Secondary Deflation when Research Assistant to Hayek

Austrian Economics Newsletter: After you moved to England in 1933 you became a research assistant to Hayek. What type of topics were usually of interest in the famous Hayek-Robbins seminar?

Ludwig M. Lachmann: In general, problems of the business cycle and of capital theory. I actually worked on secondary depressions. That is to say, what Hayek first used to call the process of secondary deflation, a word that had been coined by a German economist to denote that part of the process of depression which goes beyond any kind of primary maladjustment. That is to say, that kind of depression that would not be an adjustment process in the Hayekian sense. It was by then (1933) admitted that a depression of this kind could develop and I think everybody admitted that by 1933 the world was in a process of secondary depression.

—Ludwig M. Lachmann, “An Interview with Ludwig Lachmann,” Austrian Economics Newsletter 1, no. 3 (Fall 1978), https://mises.org/library/interview-ludwig-lachmann (accessed January 29, 2020).

On the Meaning of “Gross” vs. “Net,” “Domestic” vs. “National,” and “Product” in the “Gross Domestic Product” Statistic

A fundamental concept around which aggregate income accounting is based is GDP. It is defined as the aggregate economic output of the economy, and is meant to measure the total amount of goods and services available for government and consumers to consume. (For ease of exposition, I will leave out any discussion of the international sector.)

To understand what is meant by GDP, let’s consider each term separately. Let’s start with the term “domestic.” The adjective “domestic” replaced the previous adjective “national” in the 1970s. Before that time we talked about Gross National Product, not Gross Domestic Product. The difference between the two is usually small, but it makes a good question for grilling students. GDP is a measure of gross final domestic output, where “domestic” means output physically produced in the United States, and “national” means output produced by US national firms and citizens. The domestic production measure is used by most countries around the world and is easier to measure than the national production since, with globalization, it is hard to tell what is a US firm and what is a foreign firm. So “domestic” is simply a descriptor of some technical issues about measuring aggregate output.

Let’s next consider the term “gross.” In aggregate income accounting, the term “gross” has a specific meaning. It means that the measure includes production that is used for investment, and thus will not be available for consumption by government or consumers. After one subtracts that investment, one has net domestic product (NDP) and it is NDP that represents the output available for private and government consumption. Net production is gross production minus investment. The reason economists don’t focus on NDP, and instead focus on GDP is that we don’t have good measures of investment. To arrive at NDP we generally simply subtract a set percentage — what is called a capital consumption allowance. Given that fact, we often use the GDP measure as a proxy for final output of the economy.

Finally, let’s consider the meaning of the third term “product.” “Product” in aggregate income accounting is just another term for output. One could have as well called it gross domestic output. Skousen [2014], in his Wall Street Journal valedictory op-ed article calls his concept of gross output a “better economic measure” than GDP because it is a supply-side statistic that measures the production side of the economy, whereas the current measure of output, GDP, measure the demand side of the economy. That characterization doesn’t fit with the aggregate accounting conventions; GDP is a measure of the productive side of the economy just as much as gross output is.

—David Colander, “Gross Output: A New Revolutionary Way to Confuse Students about Measuring the Economy,” Eastern Economic Journal 40, no. 4 (September 2014): 452-453.

The Key Problem with Rational Expectations Is They Assume Everyone Is an Accomplished Econometrician and a 100% Monetarist

Austrian Economics Newsletter: What do you see as the fundamental problem with the rational Expectations literature?

Gottfried von Haberler: Oh, they go much too far. They are saying, for instance, that monetary policy cannot have any effect because people immediately anticipate it; that, when they read in the paper that the money supply has gone up, everyone concludes that the price level is going up, and everyone takes immediate actions which make the effect nugatory. So they, in effect, assume that everybody is an accomplished econometrician, and a one hundred percent monetarist, which I think is simply not so.

—Gottfried von Haberler, “Between Mises and Keynes: An Interview with Gottfried von Haberler,” Austrian Economics Newsletter 20, no. 1 (Spring 2000), https://mises.org/library/between-mises-and-keynes-interview-gottfried-von-haberler (accessed January 28, 2020).

There Is Very Little Economic Content in Much of Modern Economics; What They Are Doing Is Engineering and Applied Mathematics

Buchanan has also long been considered a proponent of the Austrian view of the market process. In this regard he is more than just a “fellow traveler”; his work has played an important role in helping to distinguish between the theory of the market as a process and the alternative, neoclassical theory of competitive equilibrium. Thus, in addition to his seminal work on subjective cost theory, Buchanan has helped clarify the Austrian view of the market as a process.

In his 1963 presidential address to the Southern Economic Association, Buchanan explained how the economics profession was apparently being led astray by its focus on the “theory of resource allocation.” He forcefully argued that the standard neoclassical definition of economics as the study of the allocation of scarce mean among competing ends “has served to retard, rather than advance scientific progress.” The reason for this, according to Buchanan, is that there is very little economic content in much of modern economics. What neoclassical economics, all too often involves is a computation problem, the computation of equilibrium prices, for example which “to the subjectivist, [seems] an absurd exercise.”

A good example is the work of Nobel Laureate Tjalling Koopmans, who began his career by working out the optimal allocation of a set of tankers carrying oil across the Atlantic during World War II. Buchanan properly labels such work as engineering, not economics, and claims that he must have been “a confirmed subjectivist long before I realized what I was because I recall thinking in 1946, when Koopmans was lecturing… at the University of Chicago, that there seemed to be absolutely no economic content in what he was doing….”

Buchanan has attempted to persuade the economics profession to abandon its fixation on allocation problems per se, for “if there is really nothing more to economics than this, we had as well turned it all over to the applied mathematicians.” This does appear to be the direction the profession has been heading; for “developments of note... during the past two decades consist largely of improvements in ... computing techniques, in the mathematics of social engineering.”

Instead of becoming weakly-trained mathematicians (at least by the standards of professional mathematicians), Buchanan suggested replacing the theory of resource allocation with the theory of markets.

—Thomas J. DiLorenzo and Walter E. Block, introduction to An Austro-Libertarian Critique of Public Choice, Economy and Society (New York: Addleton Academic Publishers, 2016), Kindle e-book.

The Essence of Say's Law of Markets Is: Unless We First Produce We Cannot Consume; Unless We First Supply We Cannot Demand

The more complex the network of exchange, the more difficult the direct barter of goods one for another. Rather than be frustrated and disappointed in not being able to directly find trading partners who want the goods they have for sale, people start using some commodity as a medium of exchange. They first trade what they have produced for a particular commodity and then use that commodity to buy the things they desire from others. When that commodity becomes widely accepted and generally used by most, if not all, transactors in the market, it becomes the money-good.

It should be clear that even though all transactions are carried out through the medium of money, it is still, ultimately, goods that trade for goods. The cobbler makes shoes and sells them for money to those who desire footwear. The cobbler then uses the money he has earned to buy the food he wants to eat. But he cannot buy that food unless he has first earned a certain sum of money by selling a particular quantity of shoes. In the end, his supply of shoes has been the means for him to demand a certain amount of food.

This, in essence, is the meaning of Say’s Law. The nineteenth-century French economist Jean-Baptiste Say called it “the law of markets”: that is, unless we first produce we cannot consume; unless we first supply we cannot demand. But how much of our supply others are willing to take is dependent on the price at which we offer it to them.

—Richard M. Ebeling, “The Myth of Global Gluts and the Reality of Market Change,” in Austrian Economics and Public Policy: Restoring Freedom and Prosperity (Fairfax, VA: The Future of Freedom Foundation, 2016), Kindle e-book.

Eugen von Böhm-Bawerk v. Keynes on Savings: An Economically Advanced Nation Does NOT Engage in Hoarding

But then why teach the paradox of thrift at all? Not only is it historically unproved, but it is fundamentally flawed. The problem is that Keynesians treat savings as if it disappears from the economy, that it is simply hoarded or left languishing in bank vaults, uninvested. In reality, saving is simply another form of spending, not on current  consumption, but on future consumption. The Keynesians stress only the negative side of saving, the sacrifice of current consumption, while ignoring the positive side, the investment in productive enterprise. The Austrian economist Eugen Böhm-Bawerk stressed the positive side of saving: “For an economically advanced nation does not engage in hoarding, but invests its savings. It buys securities, it deposits its money at interest in savings banks or commercial banks, puts it out on loan, etc.” (1959 [1884], 113).

—Mark Skousen, The Big Three in Economics: Adam Smith, Karl Marx and John Maynard Keynes (Armonk, NY: M. E. Sharpe, 2007), 179-180.

GO Is a Supply-Side Statistic Reflecting Say’s Law While GDP Is a Demand-Side Statistic Reflecting Keynes’s Law

I consider the adoption of Gross Output on equal footing with GDP as perhaps the most significant advance in national income accounting since World War II. Steve Hanke says GO is a reflection of Say’s law, a supply-side statistic, while GDP is a symbol of Keynes’s law, a demand-side number (Hanke 2014). The difference is stark. If you use supply-side GO as the proper measure of economic activity, business investment is the most important sector. But if you rely on Keynesian GDP, consumer spending and government stimulus are the most important factors. The rise of GO may also signify a second round of debates between Hayek and Keynes, with GO representing the Austrian perspective (the stages of production), and GDP representing the Keynesian perspective (final effective demand).

—Mark Skousen, introduction to the new revised edition of The Structure of Production, new rev. ed. (New York: New York University Press, 2015), xvi.

One Must Be Free to Sell Property If the Information Necessary for the Market to Operate Is to be Created

We cannot overlook the fact that when Lionel Robbins was writing his 1934 book, The Great Depression, he took the opportunity, a year before Hayek wrote on the subject, to make some brief critical comments on the proposals for competitive socialism. According to Robbins, it is not enough for managers in the socialist system to try to “play” at competition and “compete” with each other when buying and selling their products, as if they were acting in a capitalist system. He feels that such proposals involve a simplistic conception of the economic system, as if it were a static system in which prices and all other information were generated ipso facto, in an objective manner, by the force of consumer demand.

In contrast, Robbins stresses that in the real world, tastes, technology, resources, and in general, all knowledge is in a process of continual change, and therefore, “the entrepreneur must be at liberty to withdraw his capital altogether from one line of production, sell his plant and his stocks and go into other lines. He must be at liberty to break up the administrative unit”. In short, one must be free to sell property if the information necessary for the market to operate is to be created, and this is clearly incompatible with public ownership of the means of production and the centralized control of the economic system which it ultimately entails. Hence, we see that along with the arguments against the computational, or purely algebraic, solution discussed earlier, Robbins offers a series of comments on “artificial competition”, and though they are brief, they are not altogether off-base.

—Jesús Huerta de Soto, Socialism, Economic Calculation and Entrepreneurship, trans. Melinda Stroup, New Thinking in Political Economy (Cheltenham, UK: Edward Elgar Publishing, 2010), 183-184.

Oskar Lange's “Two Pages of Fiction” (His “Refutation” of Mises over Socialist Calculation) Is Founded on the Illiterate Expression “Given Data”

There is endless repetition of the claim that Professor Oskar Lange in 1936 refuted the contention advanced in 1921 by Ludwig von Mises that ‘economic calculation is impossible in a socialist society.’ The claim rests wholly on theoretical argument by Oskar Lange in little more than two pages, 59 to 61, in the most widely known reprint of his original essay, with Fred M. Taylor, On the Economic Theory of Socialism (ed. B. E. Lippincott, University of Minnesota Press, 1938). It will be timely to analyse this argument clause by clause. We shall here indent Lange’s successive assertions with the crucial terms in italics, and examine their validity and bearing one by one. . . .

Lange continues:

The economic problem is a problem of choice between alternatives. To solve the problem three data are needed; (1) a preference scale which guides the acts of choice; (2) knowledge of the ‘terms on which alternatives are offered’; and (3) knowledge of the amount of resources available. Those three data being given, the problem of choice is soluble. 

The illiterate expression ‘given data’ constantly recurs in Lange. It appears to have an irresistable attraction to mathematical economists because it doubly assures them that they know what they do not know. It seems to bewitch them into making assertions about the real world for which they have no empirical justification whatever. On the confusion supported by this pleonasm the whole of Lange’s ‘refutation’ of Mises’ argument (and most of the theory of resource allocation descending from it) is based. Note the following:

. . . it is obvious that a socialist economy may regard the data under 1 and 3 as given, at least in as great a degree as they are given in a market economy. 

—F. A. Hayek, “Two Pages of Fiction: The Impossibility of Socialist Calculation,” Economic Affairs 2, no. 3 (April 1982): 135-136.

Böhm-Bawerk Sought a Universal Notion of Capital, but Menger Developed a Historically Specific View with Microeconomic Foundations

Just as in their respective treatments of the goods-character of goodwill, Menger’s sympathy for the everyday practices of economic agents and Böhm-Bawerk’s lack of concern for them are evident in their competing capital concepts. Menger’s respect for the lessons of ‘experience’ (a word he used tirelessly) led him to restrict capital to its actual role as diverse possessions which generate private incomes in a monetary economy (capital in the acquisitive sense). Böhm-Bawerk recognized the dual meaning of capital—that is to say, capital in the acquisitive sense, and capital in the technical sense—as an instrument of production. However, the centrality of the technical element in his choice of social capital as a guiding conception did not lead him beyond capital as an aggregate of produced goods with a durable foundation. He sought a universal notion, whereas Menger developed a view as to the content of capital historically specific to private ownership and entrepreneurial economizing in a monetary economy. In such an economy, entrepreneurial behaviour was not merely perfunctory or secondary to the technical dictates of the so-called Böhm-Bawerkian ‘instruments of production’. Menger’s theories of capital and money had microeconomic foundations: uncertain needs were served by holding cash balances, including speculative balances. The use of money cannot be precisely scheduled; it acts as a stock against the disappointment of individuals’ plans in uncertain conditions. Indeed, ‘Menger again and again stresses that demand is fickle, that it changes in unpredictable ways and that such changes bring about economic frictions’ (Streissler 1973). It is precisely in these conditions of uncertainty generated through demand fluctuations that the concept of capital in the acquisitive sense is formed in the minds of Menger’s entrepreneurs.

—A. M. Endres, Neoclassical Microeconomic Theory: The Founding Austrian Version, Foundations of the Market Economy (London: Routledge, Taylor and Francis e-Library, 2002), 171-172.

The Consumption-Theory of Time Preference Integrates the Theory of Capital and Interest into the General Theory of Prices

Let us highlight the significance of this explanation within the overall theoretical framework of Misesian economics. Consumption here appears as the root of all economic phenomena. Carl Menger and his disciples had argued that consumer choices directly determine the prices of consumers’ goods, and that indirectly they also determine the prices of producers’ goods. Now time preference, too, and with it the phenomena of capital and interest appear to be rooted in consumption. The great attraction of this explanation (at least from Mises’s point of view) was that it did not stress any psychological dispositions of man, but relied on the fundamental fact that there can be no human action without consumption. The consumption-theory of time preference thus seamlessly integrates the theory of capital and interest into the general theory of prices. In the field of interest—as in the broader market process—the consumer is sovereign.

—Jörg Guido Hülsmann, Mises: The Last Knight of Liberalism (Auburn, AL: Ludwig von Mises Institute, 2007), 779.

Time Preference Is Only the Proximate Cause of Interest; the Ultimate Cause Was the Necessity of Consumption

Like Böhm-Bawerk, Mises believed that time preference was only the proximate cause of interest. But rather than seeing the ultimate cause in certain psychological dispositions of the human being, he followed Frank Fetter and Franz Cuhel in arguing that the ultimate cause was the necessity of consumption. The fact is that human beings cannot survive if they do not consume. Hence there must be some time preference in human action or the human race would perish. This does not mean that time preference is the only factor determining human actions. It means that in order to survive, human beings must at some point prefer shorter production processes to longer ones, even though the longer ones would be more physically productive.

Mises argued that one would always choose the longest production process if one could disregard the need for survival through time. It is the need to survive that prompts the acting person also to consider the passage of time and to prefer, at some point, sooner results to later ones.

—Jörg Guido Hülsmann, Mises: The Last Knight of Liberalism (Auburn, AL: Ludwig von Mises Institute, 2007), 778.

Time-Preference Is NOT Always Preference for Present Goods As Compared with Future Goods

It should, however, be carefully observed that time-preference is not always preference for present goods as compared with future goods. We sometimes, indeed very frequently, prefer to have certain things in the future. After any meal, the present use of the remaining food in the pantry, the cellar, the granary, is worth less than its possibility of future uses, some of which are a few hours, others a few days, others perhaps weeks distant. The changes of the seasons with their effects on the abundance of plant and animal life cause a pretty regular cycle of valuations. When the crops are harvested in the fall, the farmer, while setting apart some of the fruits of the field to provide for the present nourishment of himself and family, yet stores up the rest for later use. His immediate needs are over-supplied, and his anticipated future needs induce him to save. In a fishing tribe after a great haul of fish a present fish is worth less than the certainty of a fish six months later when fish will be scarce. After a successful buffalo hunt, when all the members of the tribe are sated with meat, present meat is worth less than the chance of an equal amount of meat any time for nearly a year. Ice has less value in winter both because the need for ice in refrigerators is less, and because ice is more plentiful. In January one would gladly exchange a larger amount of present ice for a smaller amount to be delivered the following July. Crops of fruit, vegetables, etc., are on the average worth less per unit at the moment they are gathered than at any other time in the year until the next crop is due.

—Frank A. Fetter, Economics, vol. 1, Economic Principles (1915; repr., New York: The Century Co., 1928), 237-238.

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.

Economy-wide Disequilibria in the Context of a Changing Capital Structure Escape the Attention of Growth Theorists and Macroeconomists

Capital-based macroeconomics rejects the Keynes-inspired distinction between macroeconomics and the economics of growth. This unfortunate distinction, in fact, derives from the inadequate attention to the inter-temporal capital structure. Conventional macroeconomics deals with economy-wide disequilibria while abstracting from issues involving a changing stock of capital; modern growth theory deals with a growing capital stock while abstracting from issues involving economy-wide disequilibria. With this criterion for defining the subdisciplines within economics, the thorny issues of disequilibrium and the thorny issues of capital theory are addressed one at a time. Our contention is that economic reality mixes the two issues in ways that render the one-at-a-time treatments profoundly inadequate. Economy-wide disequilibria in the context of a changing capital structure escape the attention of both conventional macroeconomists and modern growth theorists. But the issues involving the market’s ability to allocate resources over time have a natural home in capital-based macroeconomics. Here, the short-run issues of cyclical variation and the long-run issues of secular expansion enjoy a blend that is simply ruled out by construction in mainstream theorizing.

—Roger W. Garrison, Time and Money: The Macroeconomics of Capital Structure, Foundations of the Market Economy (London: Routledge, 2002), 34.

The Rate of Interest Is NOT Set in the Loan Market; Interest Is a General Phenomenon Pervading All Sectors of the Market

Another possible objection to Mises’s treatment of interest is that it focuses on real goods rather than money. After all, isn't interest related to how much the lender charges on a loan of money? Why isn't the interest rate simply the price that balances the supply and demand for loanable funds?

Here the answer is that Mises, following Böhm-Bawerk, views interest as a general phenomenon that pervades all sectors of the market. From this perspective, it’s not the case that the rate of interest is “set” in the loan market, and then ripples out to other markets where people adjust their behavior based on the interest rate. On the contrary, in a market free from outside interference, individuals’ subjective time preferences manifest themselves in every market. Time preference influences the supply and demand in the loanable funds market, but time preference also regulates how much a home builder will pay today for the lumber, shingles, nails, and so on that will yield a house to be sold in a year’s time. The implied rate of return on a production project—in other words, the percentage excess of the total revenues compared to the total monetary expenses—is called originary interest. Originary interest is ultimately determined by subjective time preference because it reflects the fundamental difference in valuation between present and future goods.

—Robert P. Murphy, Choice: Cooperation, Enterprise, and Human Action (Oakland, CA: Independent Institute, 2015), e-book.