The First-Round Effect May Explain the Formation of Asset-Price Bubbles, E.g. the 2000s Real Estate Booms in Spain and in Ireland

The first-round effect may also explain the formation of asset-price bubbles since they are the best evidence that prices do not rise evenly and proportionally, as in Friedman’s notion of helicopter money, but rather unevenly and disproportionately, as described by Cantillon and Austrian economists. Indeed, if money was neutral and the quantity theory of money held, asset-price bubbles—meaning the relative overvaluation of particular asset prices—would not exist. They occur due to the expansion of credit and its continuous inflow to a given asset market, in line with the Cantillon effect. Importantly, there are strong arguments that asset-price bubbles threaten financial stability and that they can lead to a deeper recession in comparison to a business cycle not accompanied by a financial bubble. Meanwhile, central banks, including the ECB, do not take into account asset-price inflation, instead focusing on price stability narrowly defined as stability of the CPI. Hence, it seems that central banks should change their stance on this matter and also monitor asset prices—otherwise, there is a risk of conducting an overly loose monetary policy, leading to imbalances in the economy and financial instability despite stable consumer prices and thus an apparent neutrality of money (as the proposals for price stabilization are based on the notion of neutrality of money). 

This is exactly what happened in the euro area in the 2000s. Although the CPI rate did not significantly exceed the ECB’s target in the first half of the decade, the loose monetary policy of the central bank (interest rates too low for too long, at least for some countries of the euro area) led to a business cycle, and real estate booms in countries of the euro area where the growth in the money supply was the highest (or where the new money mainly went), in particular Spain and Ireland.

—Arkadiusz Sieroń, “Hayek and Mises on Neutrality of Money: Implications for Monetary Policy,” in Banking and Monetary Policy from the Perspective of Austrian Economics, ed. Annette Godart-van der Kroon and Patrik Vonlanthen (Cham, CH: Springer International Publishing, 2018), 157-158.

The Term “Neutral Money” Gained Recognition in the English Language Literature through Hayek’s Publications

The neutrality of money means the lack of effects of monetary phenomena on real variables.³ There are a few different notions of neutrality of money, depending on how one defines “monetary phenomena.” Probably the most important notion, which we call “dynamic neutrality,” implies that changes in the supply of money only affect nominal variables, while real variables, such as relative prices, production, or employment, remain unaffected. Conversely, the non-neutrality of money means changes in the money supply have an impact on real phenomena.

The concept of neutrality of money is a central economic issue widely discussed from the very beginning of economics as a science. It is sufficient to mention the quantity theory of money formulated at first by Locke, which basically states that the level of prices is always in proportion to the quantity of money. It was probably formulated and believed by classical economists as a reaction against mercantilists’ inflationism, but that reaction was exaggerated and hampered the genuine development of monetary economics. The quantity theory of money is true but only from the point of view of comparative statics. One economy with twice the money supply of another but with no other differences should have twice as high a general price level. However, it does not follow that doubling the money supply only leads to doubling all prices. For the neutrality of money to hold from the dynamic perspective, several conditions must be fulfilled.⁵

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³ The term “neutral money” gained recognition in the English language literature through Hayek’s publications. However, it was in use earlier among Continental economists.

⁵ According to Hayek (2008a [1935]), there are three conditions for the neutrality of money: constant total money stream, perfectly flexible prices, and long-term contracts based on a correct anticipation of future price movements.

—Arkadiusz Sieroń, “Hayek and Mises on Neutrality of Money: Implications for Monetary Policy,” in Banking and Monetary Policy from the Perspective of Austrian Economics, ed. Annette Godart-van der Kroon and Patrik Vonlanthen (Cham, CH: Springer International Publishing, 2018), 154.

A Serious Shortcoming of Böhm-Bawerk’s Theory of Capital Was Its Limitation to Circulating Capital Only

A serious shortcoming of Böhm-Bawerk’s theory of capital was its limitation to circulating capital only. Not surprisingly, several attempts were made by economists working in the Austrian tradition to overcome this limitation and to extend the analysis to fixed capital (see, in particular, Åkerman, 1923-24; Wicksell, 1923; and Hayek, 1941). Studying the problem of fixed capital within an Austrian framework of the analysis was also a major concern of John Hicks in Capital and Time (1973).

According to Hicks, fixed capital goods ‘are “durable-use goods”; their essential characteristic is that they contribute, not just to one unit of output, at one date, but to a sequence of units of output, at a sequence of dates.’ Because fixed capital gives rise to intertemporal joint production, the flow input-point output conception underlying Böhm-Bawerk’s approach to capital theory has to be replaced by that of ‘flow input-flow output’ processes. As Hicks put it:

While the old Austrian theory was ‘point output’ (its elementary process having a single dated output), we shall use an elementary process that converts a sequence (or stream) of inputs into a sequence of outputs. Our conception of capital-using production is thereby made much more general.

—Christian Gehrke and Heinz D. Kurz, “Hicks’s Neo-Austrian Theory and Böhm-Bawerk’s Austrian Theory of Capital,” in Capital, Time and Transitional Dynamics, ed. Harald Hagemann and Roberto Scazzieri, Routledge Studies in the History of Economics 96 (London: Taylor & Francis e-Library, 2008), 84.

Keynes’s Notion of a Productive Structure Consisting of ONLY Two Stages Leads Him into the Trap of the “Paradox of Thrift”

Hayek, in his detailed critique of both volumes of Keynes’s A Treatise on Money (1930), accuses Keynes of entirely ignoring the theory of capital and interest, particularly the work of Böhm-Bawerk and the other theorists of the Austrian School in this regard. According to Hayek, Keynes’s lack of knowledge in this area accounts for the fact that he overlooks the existence of different stages in the productive structure (as Clark had done and Knight later would) and that he ultimately fails to realize that the essential decision facing entrepreneurs is not whether to invest in consumer goods or in capital goods, but whether to invest in production processes which will yield consumer goods in the near future or in those which will yield them in a more distant future. Thus Keynes’s notion of a productive structure comprised of only two stages (one of consumer goods and another of capital goods) and his failure to allow for the temporal aspect of the latter, nor for the consecutive stages which compose it, leads him into the trap of the “paradox of thrift,” the fallacious theoretical rationale which we explained in chapter 5.⁷⁶

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⁷⁶ It is important to remember that John Maynard Keynes himself explicitly and publicly admitted to Hayek that he lacked an adequate theory of capital. In Keynes’s own words:

Dr. Hayek complains that I do not myself propound any satisfactory theory of capital and interest and that I do not build on any existing theory. He means by this, I take it, the theory of capital accumulation relatively to the rate of consumption and the factors which determine the natural rate of interest. This is quite true; and I agree with Dr. Hayek that a development of this theory would be highly relevant to my treatment of monetary matters and likely to throw light into dark corners.

—Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles, trans. Melinda A. Stoup (Auburn, AL: Ludwig von Mises Institute, 2006), 560-561, 561n.

The Central Problem: How the Existence of Non-permanent Resources Increases the Permanent Income Stream

The non-permanent nature of all ‘wasting assets’ creates a problem which is not dealt with in the theory of timeless production. These assets cannot be directly used to contribute to the output of the time when they have ceased to exist. Insofar as their existence does help to maintain output permanently above the level at which it could be kept with the help of the permanent resources alone, it must do so in an indirect manner. If the fact that we have command over resources which remain useful only for a limited period of time did not help us to use the services of the permanent resources more effectively, it would be quite impossible to keep our income permanently above the level where it would stay if these non-permanent resources had never been available. We might stretch their use over a longer period of time, but ultimately we should inevitably exhaust them and should then have to be content with what services the permanent resources could render by themselves. It is this problem of why the existence of a stock of non-permanent resources enables us to maintain production permanently at a higher level than would be possible without them, which is the peculiar problem connected with what we call capital.

—F. A. Hayek, The Collected Works of F. A. Hayek, vol. 12, The Pure Theory of Capital, ed. Lawrence H. White (Indianapolis: Liberty Fund, 2007), 74.

Hayek Also Distinguishes Between (a) Factors that Yield Fixed Streams of Service Each Period and (b) Factors Whose Use Today Diminishes their Future Usefulness

The second important distinction is between (a) factors that yield fixed streams of service each period—namely, simple labor and permanent non-labor input sources—and (b) factors whose use today diminishes their future usefulness and raises the problem of maintenance. The first group of factors, apart from labor, can be called economic “land” goods, whether given by nature (David Ricardo’s “original and indestructible powers of the soil”) or manmade (Hayek’s example in The Pure Theory of Capital was a railroad tunnel that will need no maintenance once excavated). The second group encompasses all impermanent capital goods, from one-use blasting caps to depletable natural resource deposits to imperfectly durable machines. The simplified production model of Prices and Production treated all value-adding inputs, being applied in consecutive stages to advance intermediate goods toward final consumption, as coming from type (a) factors. The model reduced type (b) factors, impermanent capital goods, to intermediate goods. Knight’s model neglected impermanent capital goods in a different way. Its construct of a perpetual capital stock implied that the maintenance or replacement of any impermanent tools is automatic, embodied in the decision about the permanent level of future consumption.

—Lawrence H. White, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 11, Capital and Interest, by F. A. Hayek (Chicago: University of Chicago Press, 2015), xxv.

Hayek Distinguishes Between (a) INHERITED Capital Goods and (b) Intermediate Goods or Capital Goods TO BE PRODUCED

For Hayek’s model there are two important distinctions among factors of production. The first distinction is between (a) inherited capital goods, or goods already existing at the moment that a production plan is being made, and (b) intermediate goods, or capital goods (of greater or lesser permanence) to be produced as part of a sequence of production steps leading to final output. Hayek’s exposition in Prices and Production neglected inherited capital goods. It depicted the first production stage as involving only land and labor, which created intermediate goods that then progress through subsequent production stages toward final sales. Knight’s model, by abstracting from roundabout production, abstracts entirely from intermediate goods. It offers only undifferentiated capital (the inherited Crusonia plant), which instantly yields consumption.

—Lawrence H. White, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 11, Capital and Interest, by F. A. Hayek (Chicago: University of Chicago Press, 2015), xxv.

Goods Are Capital Goods Or Consumers’ Goods Depending ONLY on the Purpose for Which They Are Purchased and NOT on their Physical Characteristics

Closely paralleling the concepts of productive expenditure and consumption expenditure are the concepts of producers’ goods and consumers’ goods.

Producers’ goods or, what is a synonymous expression, capital goods, are goods purchased for the purpose of making subsequent sales.

Consumers’ goods are goods purchased not for the purpose of making subsequent sales. 

The distinction between capital goods and consumers’ goods is exclusively one of the purpose for which the goods are purchased—for business purposes or not for business purposes—and not at all a matter of their physical characteristics. The roast beef purchased by a restaurant and the washing machine purchased by a laundromat are both capital goods. Exactly the same kind of roast beef and washing machine purchased by a housewife are consumers’ goods.

The reason that the purpose for which they are purchased is the crucial distinction has already been indicated. Physically, the roast beef and the washing machine are consumed, whether purchased for business purposes or purchased not for business purposes. In both cases, there is, in this instance, a physical production that takes place in which the goods are consumed: the raw roast beef is consumed in producing a cooked one, and the washing machine is consumed in producing cleaned clothes. And thus, both for the housewife and for the business enterprises, there is even a productive consumption in the physical sense.

But beyond the physically productive consumption comes a physically unproductive consumption: the cooked roast beef is eaten and the cleaned clothes get dirty in the wearing. At this point, all trace of the goods purchased by the housewife has simply disappeared from her possession. (In the case of durable goods, such as the washing machine, all trace of the relevant portion of the good’s life has disappeared). But by this same point, or earlier, the restaurant and laundromat have obtained the means of replacing, and more than replacing, the goods they have purchased. The goods they have purchased, when one allows for their replacement by way of purchase, with funds earned from their very own employment, and not consumed—they are replaced by virtue of their own use, together with a surplus.

The roast beef of the restaurant and the washing machine of the laundromat, by virtue of being purchased for the purpose of making subsequent sales, and then by way of using the resulting sales proceeds to make replacement purchases, are reproductively employed. The restaurant’s roast beef and the laundromat’s washing machine are, as it were, employed in the production of roast beefs and washing machines, or their equivalent in other goods, as wheat seed is employed in the production of wheat. And thus in the fullest sense they represent wealth employed in the production of wealth, and are capital goods, even though from a strictly physical standpoint, a roast beef cannot be used to produce roast beefs, and a washing machine cannot be used to produce washing machines. 

—George Reisman, Capitalism: A Treatise on Economics (Ottawa, IL: Jameson Books, 1998), 445.

Hayek Discusses a SHRINKAGE of the PRICE MARGINS When an Increase in the Rate of Saving Lowers the Equilibrium Rate of Interest

To assist in the explanation of these structural changes which occur periodically under a system of capitalistic production, Hayek invokes an ingenious relationship between changes in the rate of interest, and the changes which take place in the relative values of different goods, used at different stages in the process of production. He states that there will be a difference between the value of a unit of output from one stage of production and the value of the unit of output at the succeeding stage, — and this difference he calls a “price margin.” Thus for any stage, the selling price of its output exceeds the value of the input of raw materials, labour, etc., by an amount which constitutes the source of interest whilst,  “in a state of equilibrium, these margins are entirely absorbed by interest.” This would seem to follow from Hayek’s particular interpretation of economic equilibrium as depending on a certain relationship between the prices of producers’ goods and the prices of consumers’ goods, a relationship which will be solely determined by the preference of consumers as between saving and spending,

Every given structure of production, i.e., every given allocation of goods as between different branches of production requires a certain definite relationship between the prices of the finished products and those of the means of production. In a state of equilibrium, the difference necessarily existing between these two sets of prices must correspond to the rate of interest. . . . 

Under barter conditions, the rate of interest, and thus these price relationships, will be unlikely to diverge from their equilibrium values since “. . . the reciprocal gains and sacrifices of saving borrowing and lending are concretely juxtaposed and deviations from an equilibrium position are more obviously and more directly carry their penalties with them.” Likewise in a money economy, in which the supply of credit is kept equal to the supply of savings, there will tend to be a close correspondence between changes in price margins and in the rate of interest.

An increase in the rate of saving which lowers the equilibrium rate of interest will, Hayek suggests, involve a corresponding shrinkage of the price margins. This is because greater saving leads both to a reduction in the demand for consumers’ goods which reduces their prices, and the prices of the goods at the stages immediately preceding; and also to a rise in the demand for, and in the price of, products at the earlier stages, and the latter change is transmitted towards the later stages, (but with diminishing intensity), until the price margins are again all equal, and equivalent to a lower rate of interest.

—G. F. D. Palmer, “The Trade Cycle Theories of R. G. Hawtrey and F. A. von Hayek, with Particular Reference to the Rôle Attributed by Each to the Rate of Interest” (master’s thesis, University of Cape Town, July 1951), 27-29.

Klein-Melvin (1982) Spuriously Argue That Banking Is a Natural Monopoly Because of Economies of Scale in Building Public Confidence

 A third type of spurious argument is that banking is a natural monopoly because of economies of scale in building public ‘confidence.’ A well-known version is the Klein-Melvin (1982) argument that public confidence in the value of a currency depends on confidence-building expenditures that involve certain fixed costs, the presence of which implies that one bank could always produce confidence more cheaply than two or more could. Klein and Melvin go on to suggest that the government would have an advantage in providing this confidence because its ability to tax implies that it does not need to hold reserves to maintain confidence as private banks would. There are a number of problems with this argument:

It depends on the assumption that competitive banks would issue inconvertible currencies, but competitive issues would actually be convertible, as discussed already, and convertibility undermines the whole thrust of the Klein-Melvin analysis. If competition leads to a credible convertibility guarantee, there should be no lack of public confidence regarding the value of the currency, and the problem that Klein and Melvin discuss does not arise. . . . 

To put it mildly, it is very difficult to make out a serious case that government intervention in the monetary system has helped promote confidence in the currency. The very problem that Klein and Melvin discuss — the question of confidence in an inconvertible currency — only arises in the first place because governments have suppressed the convertibility ‘guarantee’ of the value of the currency that private competition would have provided. Far from providing the public with currencies in which they could have confidence or promoting public confidence in private currencies, government policy has often been designed to compel the public to use currencies in which they had little or no confidence.

—Kevin Dowd, Competition and Finance: A Reinterpretation of Financial and Monetary Economics (Houndmills, UK: Macmillan Press, 1996), 202-203.

The Diamond-Dybvig Model Is Sometimes Described as a “Bubble” or “Sunspot” Theory of Bank Runs

If bank runs were always confined to banks that were already (pre-run) insolvent [when liabilities are greater than its assets], then runs would not be a problem, but, instead, largely salutary. In other industries, an insolvent firm’s creditors whose debts are overdue, and who wish to cut their losses, can legally force the firm into liquidation through an involuntary bankruptcy proceeding. A run on an insolvent bank serves the same function as an involuntary bankruptcy proceeding: it is an action by the bank’s creditors, namely its depositors (or note-holders, but for simplicity we will speak only of depositors), that forces the bank into liquidation. Unlike the rule in a bankruptcy, the assets do not go pro rata to all creditors of equal standing, but instead go preferentially to those who are first in line to redeem their claims (a possibly problematic feature of deposit contracts that will concern us later). The run is salutary in that it closes the insolvent bank immediately, before the bank squanders even more depositor wealth, and goes even further into the red. The run cuts the depositors’ potential losses in the aggregate. The threat of a run, like the threat of bankruptcy in other industries, provides useful discipline. It forces banks to invest smartly, and to work vigorously to avoid insolvency or even the appearance of insolvency.

A problem arises, however, if depositors with imperfect information sometimes run on banks that are not (pre-run) insolvent. In an influential article, Douglas Diamond and Philip Dybvig (1983) emphasized that a run itself can cause a bank to default that would not otherwise have defaulted. A bank forced to liquidate assets hastily may have to accept less for them than they would otherwise be worth, an event known as suffering “fire-sale” losses. A bank run can thereby be a self-reinforcing equilibrium: if enough other depositors are running, the bank will incur large fire-sale losses, default becomes likely, and it becomes each depositor’s own best strategy to run.³ There is a “me-first” scramble as each depositor tries to redeem his claim ahead of others, before the bank’s funds are exhausted. In Diamond and Dybvig’s model, discussed in more detail below, the bank attempting to meet redemption demands by more than a certain proportion of its depositors will incur fire-sale losses so large that its default is a certainty. Any event that makes people anticipate a run, therefore, makes them anticipate insolvency, and so does, in fact, trigger a run. As in a rational speculative “bubble,” the induced outcome validates the anticipation, even if the anticipation is triggered by an intrinsically irrelevant event like the appearance of sunspots. The Diamond-Dybvig model is accordingly sometimes described as a “bubble” or “sunspot” theory of bank runs.

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³ In game-theoretic terms, the bank run is a Nash equilibrium. 

—Lawrence H. White, “Should Government Play a Role in Banking?” in The Theory of Monetary Institutions (Malden, MA: Blackwell Publishers, 1999), 121-122.

Edgeworth (1888) Initiated the Idea that Economies from RESERVE HOLDINGS Could Lead to a NATURAL MONOPOLY in Banking

A perennial issue in the banking literature is whether banking is a natural monopoly—are there economies of scale in banking such that only one firm can survive in the competitive equilibrium? In one way or another natural monopoly issues underlie many discussions of banking, and it is important to clarify them, because many people still believe, not only that banking is a natural monopoly, but that the monopolization of the currency supply and other aspects of present-day central banking can be justified on natural monopoly grounds. An industry can be said to be a natural monopoly if the average production cost is lower for one firm than it would be for two or more firms, and this condition requires that the production technology exhibits increasing returns to scale, to the point where all market demand is satisfied. There is nothing to prevent a second firm entering an industry characterized by natural monopoly, but average costs would be higher while both firms continued to supply the market, and these higher costs would presumably indicate scope for one firm to ‘eliminate’ the other in a mutually profitable way—bribing it to leave the market, for instance, or taking it over and then closing down its production facilities. It follows that while we might observe more than one firm in the industry over some short period, we would not expect that state of affairs to persist in the long run.

There are several reasons why banks might face increasing returns to scale that could conceivably lead to natural monopoly. One factor is economies from reserve holdings. The underlying idea goes back to Edgeworth (1888) and it has been developed since in a number of places (e.g., Porter 1961; Niehans 1978:182-4; Baltensperger 1980:4-9; Sprenkle 1985, 1987; Selgin 1989b:6-12; Glasner 1989a). These economies are based on a well known result that subject to certain plausible conditions a bank’s optimal reserves rise with the square root of its liabilities, implying that the bank’s optimal reserve ratio falls as the bank gets bigger. Given that reserves are costly to hold, a larger bank therefore faces lower average reserve costs.

—Kevin Dowd, “Is Banking a Natural Monopoly?” Laissez-faire Banking, Foundations of the Market Economy (London: Taylor & Francis e-Library, 2003), 76-77.

Free Banking Is the Necessary Precondition for Discovering Whether or Not Banking Is a NATURAL MONOPOLY

A standard proposition of modern microeconomic theory is that if there exist significant economies of scale, that is, if long-run average costs decline over the range of output demanded in the market, then only one firm will survive. Such a firm would be a “natural monopoly.” It has often been argued that banking may be a natural monopoly, and if so, the most efficient approach is to restrict competition and allow only a single issuer of banknotes, the central bank. In short, if there are large cost economies in banking, then free banking may not be an optimal solution. 

The most basic rebuttal to the natural monopoly argument is to point out that costs cannot be known to the producer (much less to the economist) prior to the process of production and a firm’s costs are likely to change when the market structure changes. From this it follows that

a governmental producer of money is not an efficient natural monopolist unless he can prevail in conditions of free entry. . . . The only operational proof that a common money is more efficient than currency competition and that the government is the most efficient provider of the common money would be to permit free currency competition. (Vaubel 1986, 933, 935)

That is, free banking is the necessary precondition for discovering whether or not banking is a natural monopoly. In the absence of such competition, those who claim that banking is a natural monopoly are guilty of making an unsupportable assertion. 

—Larry J. Sechrest, Free Banking: Theory, History, and a Laissez-Faire Model (Auburn, AL: Ludwig von Mises Institute, 2008), 162-163.

The Fed Was “Supposed” to Command Such Superior Information As Ought to Have Allowed It to See the Subprime Crisis Brewing

The most recent financial crisis has allowed the Fed to achieve one of its most impressive public relations feats, to wit: convincing the public that the crisis, instead of supplying more proof of its inadequacy, shows that it’s now working better than ever. To accomplish this, the Fed has had to argue that, had it not been for its interventions, the outcome would have been much worse. Typical of this spin is San Francisco Fed President John C. Williams’s (2012) observation that, at the end of 2008, the U.S. economy was

teetering on the edge of an abyss. If the panic had been left unchecked, we could well have seen an economic cataclysm as bad as the Great Depression, when 25 percent of the workforce was out of work. . . . Why then didn’t we fall into that abyss in 2008 and 2009? The answer is that a financial collapse was not—I repeat, not—left unchecked. The Federal Reserve did what it was supposed to do.

But did the Fed really do everything “it was supposed to do” to contain the crisis? Is it even certain that its interventions made the crisis no worse than it would have been otherwise? There are good reasons for believing that the correct answer to both questions is “no.”

The Fed was, first of all, “supposed” to command such superior information as ought to have allowed it to see the crisis, or at least some trouble, brewing. After all, according to the San Francisco Fed’s “Dr. Econ” (FRBSF 2001), “Federal Reserve operations and structure provide the System with some unique insights into the health of the financial system and the economy,” providing it “with firsthand knowledge of the conditions of financial institutions.” In fact, Fed officials never saw what hit them. As the Federal Open Market Committee’s (FOMC) 2006 transcripts make clear, that committee was convinced at that late date both that a housing market downturn was unlikely and that, if such a downturn occurred, it would not do much damage to the rest of the economy. New York Fed President Timothy Geithner, for example, observed that “we just don’t see troubling signs yet of collateral damage, and we are not expecting much,” while Janet Yellen did not hesitate to congratulate outgoing Fed Chairman Alan Greenspan for leaving “with the economy in such solid shape.”

—George Selgin, “Operation Twist-the-Truth: How the Federal Reserve Misrepresents Its History and Performance,” in Money: Free and Unfree (Washington, DC: Cato Institute, 2017), 278-279.

Why Did the 1930s Depression Last So Long? Purdue Economist James A. Estey Explained Why in Strictly Austrian Terms

Estey described in detail how the shape of the economy’s structure of production is distorted by monetary inflation, creating initially a rapid expansion in the capital-goods industry. To keep the boom going, the banks and the central banks would have to advance further credits. “This further increase, however, would have to be greater than the initial one, for the general price level and the general level of incomes have now risen. . . . It is only a question of time until the changed structure becomes impossible and the former one must be restored.” Estey believed that the expansion of bank credit to finance World War II was a classic example of Hayek’s thesis, if one considers war goods as capital. 

Why did the 1930s depression last so long? Estey gave his explanation in strictly Austrian terms:

Theoretically, there should be a steady transfer of workers and nonspecific capital from the abandoned higher stages to these lower ones. In fact, this process is slow. Shorter processes still have to be started from the beginning. Goods still have to pass through the necessary steps. In addition, it is possible only gradually, as successive stages are reached in the passage of goods to the consumer, to absorb the labor and nonspecific capital released from longer and more roundabout processes. Moreover, this delay is increased by the uncertainty of producers in respect to appropriate methods in the shortened process where a relatively smaller amount of capital and a relatively larger amount of labor are needed.

    In brief, workers and mobile resources are released from the longer processes faster than they can be absorbed in the shorter, and the consequence is a growing volume of unemployment. . . . The attempt to restore the normal levels of consumption sets up a further disturbing factor—that is deflation and a fall in prices—which lengthens the depression and adds to the obstacles facing recovery.

Estey’s coverage of Hayek’s theory is extensive. He characterized the Hayekian model as “ingenious.”

—Mark Skousen, The Structure of Production, new rev. ed. (New York: New York University Press, 2015), 87.

The Very Essence of the Market Economy Is the SPECIFICITY of Capital Goods (Some Are More Specific in Use Than Others)

What kind of conclusions can we make about the general nature of capitalistic production? Certainly, all goods are transformed into final consumption through multi-stage development, but not all are multi-staged in terms of final use. Many capital goods are highly specific in their use, especially in the earlier stages of output (raw materials, producers’ goods, etc.). Their distance from final consumption can generally be identified. 

It is a different matter for nonspecific goods, such as paper products, electricity, telephones, trucks, and other goods used in a wide variety up and down the industrial sectors. Actually, all goods vary in their degree of specificity. Some goods are extremely specific, others are very non-specific and are used in virtually all sectors of the economy. But rather than abandon the idea of stages entirely, it is better to try to identify in a general way where along the time-structure hierarchy these nonspecific goods belong.

The very essence of the market economy is the specificity of capital goods. Suppose, for the sake of argument, that all capital goods were completely nonspecific and totally versatile. This would mean that they could be transferred from one project to another at no cost. If this were the case, there would be no structure to the economy, and therefore no lags, no structural unemployment of resources or labor—in short, no business cycle. In short, capital goods are specific in nature, although some are more specific in use than others. This is the crux of macroeconomic analysis, and the reason that Lachmann and others stress the importance of the heterogeneity of capital goods (and, I might add, the labor market, although to a lesser extent). But the degree to which producer’s goods and machinery are nonspecific—that is, useable in more than one stage—is the degree to which the economy will be flexible in adjusting to monetary disequilibrium.

—Mark Skousen, The Structure of Production, new rev. ed. (New York: New York University Press, 2015), 148-149.

Complementarity Is a Condition of Plan Equilibrium (Stability); Substitutability Is a Condition of Plan Disequilibrium (Change)

Lachmann’s world is consciously similar to Schumpeter’s world of “creative destruction,” except that for Lachmann the innovating entrepreneur is not disrupting some preexisting general equilibrium. His world is one in which a continuous evolutionary process of changing patterns of capital complementarity is occurring. At any point in time, different entrepreneurs will have different and frequently incompatible production plans. Over time the market process will validate some and invalidate others. Lachmann sees the market process as tending to integrate the capital structure, in other words, rendering plans more consistent, although he is careful to add that the forces of equilibrium may be overwhelmed by the forces of change. 

The concept of the capital structure is built out of the notion of capital complementarity. A production plan is a construction of the human mind. As such it exhibits a necessary internal consistency. From the point of view of the individual planner, it might be said that the plan is always in equilibrium. The plan is always in equilibrium in the sense that every planner, being rational, may always be counted on to do the best that he can, given all the relevant constraints, where such constraints include the time available to adjust to any unexpected changes. That is to say, at any given point of time any individual planner is in equilibrium with respect to the world as he sees it at that point of time. All productive resources employed in that plan stand in complementary relationships to one another. Between any two points of time, during which unexpected changes will necessarily have occurred, resource substitutions will have been made in an attempt to adjust to the changes. Complementarity is a condition of plan equilibrium (stability); substitutability is a condition of plan disequilibrium (change). 

 —Peter Lewin, Capital in Disequilibrium: The Role of Capital in a Changing World, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2011), 134-135.

Understanding Capital Combinations Entails an Understanding of the Concepts of Complementarity and Substitutability

According to Lachmann, though the capital-stock is heterogeneous, it is not amorphous. The various components of the capital stock stand in sensible relationship to one another because they perform specific functions together. That is to say, they are used in various capital combinations. If we understand the logic of capital combinations, we give meaning to the capital structure and, in this way, we are able to design appropriate economic policies or, even more importantly, avoid inappropriate ones.

Understanding capital combinations entails an understanding of the concepts of complementarity and substitutability. These concepts pertain to a world in which perceived prices are actual (disequilibrium) prices, in the sense that they reflect inconsistent expectations, and in which changes that occur cause protracted visible adjustments. Capital goods are complements if they contribute together to a given production plan. A production plan is defined by the pursuit of a given set of ends to which the production goods are the means. As long as the plan is being successfully fulfilled, all of the production goods stand in complementary relationship to one another. They are part of the same plan. The complementarity relationships within the plan that may be quite intricate and no doubt involve different stages of production and distribution. 

Substitution occurs when a production plan fails (in whole or in part). When some element of the plan fails, a contingency adjustment must be sought. Thus some resources must be substituted for others. This is the role, for example, of spare parts or excess inventory. Thus, complementarity and substitutability are properties of different states of the world. The same good can be a complement in one situation and a substitute in another. Substitutability can only be gauged to the extent that a certain set of contingency events can be visualized. There may be some events, such as those caused by significant technological changes, that, not having been predictable, render some production plans valueless. The resources associated with them will have to be incorporated into some other production plan or else scrapped; they will have been rendered unemployable. This is a natural result of economic progress which is driven primarily by the trial-and-error discovery of new and superior outputs and techniques of production. What determines the fate of any capital good in the face of change is the extent to which it can be fitted into any other capital combination without loss in value. Capital goods are regrouped. Those that lose their value completely are scrapped. That is, capital goods, though heterogeneous and diverse, are often capable of performing a number of different economic functions.

—Peter Lewin, “Hayek and Lachmann,” in Elgar Companion to Hayekian Economics, ed. Roger W. Garrison and Norman Barry (Cheltenham, UK: Edward Elgar Publishing, 2014), 169-170.

(POST 2 OF 2) The Structure of Production Under Central Planning: Skousen’s Contribution to the Socialist Calculation Debate

Let us use the example of shoe production to demonstrate the inherent problems with central planning [and specifically under the “random pricing” scenario]. Suppose a price is set too low for the production of cowhide, causing inventories to decline and a shortage to arise. As the incentive to produce cattle declines, cattlemen fail to build up their herds for future slaughter. The central board realizes its mistake and raises the price for cowhide. This is the right decision, but it takes time for cattle producers to rebuild their herds. Meanwhile, there is a current shortage of cowhides, even at the higher price. The next level of production, leather making, is severely restricted in its output because of the cowhide shortage. It must look for substitutes, or expensive foreign imports, but the search may not be entirely successful, especially in the short run. It also takes considerable time to find synthetic leather or other substitutes. 

Now we come to the final stage of shoe production. Suppose a shoe factory has been given a quota (demand) to produce ten thousand shoes in a given time period to satisfy consumer demand. The factory possesses all the tools, labor, and materials necessary to achieve its quota except the shoe manufacturer has only enough leather to produce five thousand shoes due to the shortage of leather. 

How many shoes will be produced? Only five thousand. Half the consumer demand will be met. Output is always limited to the availability of each complementary capital good. As Menger puts it, “With respect to given future time periods, our effective requirements for particular goods of higher order are dependent upon the availability of complementary quantities of the corresponding goods of higher order.”

In sum, the shortage of cowhide leads to a shortage of leather and eventually to a shortage of shoes. In addition, those capital goods and labor associated with the shoe industry will be underemployed because of the shortage. Thus, delays, shortages and underemployment of labor and resources are inevitable under such a random pricing system. The shortage problem is intensified even more when the process of transformation involves a wide variety of complementary factors. Thus a shortage of a widely demanded complementary factor can create more havoc as the production process moves toward final consumption.

—Mark Skousen, The Structure of Production, new rev. ed. (New York: New York University Press, 2015), 173-174.

(POST 1 OF 2) The Structure of Production Under Central Planning: Skousen’s Contribution to the Socialist Calculation Debate

The concept of the structure of production is a valuable tool in the ongoing debate over economic calculation in the socialist economy. In the 1930s, a major dispute developed between the Austrian economists, led by Ludwig von Mises and Friedrich A. Hayek, and the socialist economists, led by Oskar Lange and Fred M. Taylor. In his critique of socialism, Mises argued that central planning would not work because, without competition between firms, prices could not logically be calculated, and without market prices, firms could not produce goods and services efficiently.

Oskar Lange rebutted Mises’ view by contending that central planning boards under socialism could determine prices through “trial and error.” A price could be set and the market of supply and demand could be observed. If shortages occurred, the price should be raised. If surpluses abound, the price should be lowered. Lange even went so far as to state, “Let the Central Planning Board start with a given set of prices chosen at random. . . . If the quantity demanded of a commodity is not equal to the quantity supplied, the price of that commodity has to be changed.”

Surprisingly, most economists concluded that Lange and the other “market” socialists adequately answered the Austrian challenge, although the issue is still debated today. 

However, the literature on the socialist calculation debate tends to ignore in large measure the problems arising out of the structure-of-production concept. The debate seems to focus on a “micro” approach of supply-demand factors of individual consumer and factor markets rather than the critical interrelation of economic processes. Specifically, how could a central planning board successfully use a “trial and error” method at each stage of production wherein each successive level of output depends on earlier produced inputs and working capital? After all, the setting up of a socialist state, whereby government controls the means of production, does not eliminate the intermediate stages of output. . . . 

Setting prices at random would undoubtedly create massive shortages and surpluses. But the deficiencies in one market are never isolated—they lead to disequilibrium in other related markets before and after the specific market. Moreover, it takes time to eliminate shortages and surpluses—the industrial system under central planning cannot create equilibrium overnight. Random pricing would therefore result in delays and shortages in the long and complex chain of production.

—Mark Skousen, The Structure of Production, new rev. ed. (New York: New York University Press, 2015), 172-173.

Let Us Deprive Governments or Their Monetary Authorities of ALL Power to Protect Their Money Against Competition

 About a year after being awarded the Nobel Prize in economics in 1974, he [Hayek] delivered a lecture on “International Money” in September 1975 at a conference in Switzerland. In early 1976, it was published in London as a monograph under the title Choice in Currency: A Way to Stop Inflation. He explained that under the influence of Keynes and Keynesian domination of monetary and macroeconomic policy, governments were invariably guided by short-run goals in the service of various special-interest groups. The consequence was the constant abuse of the printing press and a resulting price inflation to feed the seemingly insatiable demands of privileged and politically influential groups. 

Hayek now concluded that some method had to be found to free the ordinary citizen from the government’s monopoly control of the medium of exchange. The answer, he suggested, was allowing individuals the freedom to use whatever money they chose, instead of their being captives of the increasingly depreciated monetary unit imposed on the market by the government:

There could be no more effective check against the abuse of money by the government than if people were free to refuse any money they distrusted and to prefer money in which they had confidence. Nor could there be a stronger inducement to governments to ensure the stability of their money than the knowledge that, so long as they kept the supply below the demand for it, that demand would tend to grow. Therefore, let us deprive governments (or their monetary authorities) of all power to protect their money against competition: if they can no longer conceal that their money is becoming bad, they will have to restrict the issue.

    Make it merely legal and people will be very quick indeed to refuse to use the national currency once it depreciates noticeably, and they will make their dealings in a currency they trust.

    The upshot would probably be that the currencies of those countries trusted to pursue a responsible monetary policy would tend to displace gradually those of a less reliable character. The reputation of financial righteousness would become a jealously guarded asset of all issuers of money, since they would know that even the slightest deviation from the path of honesty would reduce the demand for their product.

Hayek’s proposal was for people to have the option to competitively select among the various currencies issued by governments.

—Richard M. Ebeling, “Friedrich A. Hayek and the Case for the Denationalization of Money,” in Monetary Central Planning and the State (Fairfax, VA: Future of Freedom Foundation, 2015), Kindle e-book.

Between Sept. 2008 & June 2014, the Monetary Base Has Increased by OVER 440% As Excess Reserves Sit at the Fed Earning Interest

What was the Federal Reserve’s response in the face of the busted bubbles its own policies helped to create? Between September 2008 and June 2014, the monetary base (currency in circulation and reserves in the banking system) has been increased by more than 440 percent, from $905 billion to more than $4 trillion. At the same time, M-2 (currency in circulation plus demand and a variety of savings and time deposits) grew by 35 percent. 

Why haven’t banks lent out more of this huge amount of newly created money, and generated a much higher degree of price inflation than has been observed so far? It is partly because, after the wild bubble years, many financial institutions returned to the more-traditional creditworthy benchmarks for extending loans to potential borrowers. That has slowed down the approval rate for new loans.

But more important, the excess reserves not being lent out by banks are collecting interest from the Federal Reserve. With continuing market uncertainties about government policies concerning environmental regulations, national health-care costs, the burden of the federal debt, and other government unfunded liabilities (Social Security and Medicare), as well as other political interferences in the marketplace, banks have found it more attractive to be paid interest by the Federal Reserve rather than to lend money to private borrowers. And considering how low Fed policies have pushed down key market lending rates, leaving those excess reserves idle, first under Ben Bernanke and now under Janet Yellen, has seemed the more profitable way of using all that lending power.

—Richard M. Ebeling, “Federal Reserve Policies Cause Booms and Busts,” in Austrian Economics and Public Policy: Restoring Freedom and Prosperity (Fairfax, VA: The Future of Freedom Foundation, 2016), Kindle e-book.

The Intl. Monetary Order of the 19th Century was the Creation of a PLANNING Mentality; Even the Gold Standard Was a Government-Managed System

In his 1942 book, This Age of Fable, German free-market economist Gustav Stolper pointed out:

Hardly ever do the advocates of free capitalism realize how utterly their ideal was frustrated at the moment the state assumed control of the monetary system. . . . A “free” capitalism with government responsibility for money and credit has lost its innocence. From that point on it is no longer a matter of principle but one of expediency how far one wishes or permits governmental interference to go. Money control is the supreme and most comprehensive of all government controls short of expropriation.

Even in the high-water mark of classical liberalism in the 19th century, practically all advocates of the free market and free trade believed that money was the one exception to the principle of private enterprise. The international monetary order of the 19th century, of which Wilhelm Roepke spoke in such glowing terms, was nonetheless the creation of a planning mentality. The decision to “go on” the gold standard in each of the major Western nations was a matter of state policy. 

A central-banking structure for the management and control of a gold-backed currency was established in each country by its respective government, either by giving a private bank the monopoly control over gold reserves and issuing banknotes or by establishing a state institution assigned the task of managing the monetary system within the borders of a nation. The United States was the last of the major Western nations to establish a central bank, but it finally did so in 1913. 

That even the gold standard was a government-managed monetary system was succinctly explained by economist Michael A. Heilperin in his book Aspects of the Pathology of Money (1968).

—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.

The Interference in the Money Market by the Central Bank Completely Changes the Process of Interest Rate Formation

Some economists argue that it is not the central bank but market participants who determine longer term credit rates. This view is influenced by the classical economic theory where the interest rate equilibrates saving and investment. As argued above, without interference from the outside, the market rate may well converge to the natural rate which equilibrates saving and investment. But the interference in the money market by the central bank completely changes the process of interest rate formation. Now it is no longer the preferences of market participants but the expected action of the central bank that is pivotal in the formation of interest rates. But can the central bank not derive the natural interest rate by carefully analyzing economic developments? Unfortunately, no model designed by an economist is capable of capturing the cumulated knowledge in the heads of all economic actors needed to calculate the correct natural interest rate. It can only emerge from their exchange in the market. Hence, despite their technical refinements, all the models used by central banks to steer the market rate to the natural rate must be inadequate and lead to errors in interest rate formation.

—Thomas Mayer, Austrian Economics, Money and Finance, Banking, Money and International Finance 8 (London: Routledge Taylor & Francis Group, 2018), 68-69.

Governments Engage in “Disguised Absolutism” When They Arrogate to Themselves the Right to Cover Deficits by Issuing Notes

The socialistic or semi-socialistic state needs money in order to carry on undertakings which do not pay, to support the unemployed, and to provide the people with cheap food. It also is unable to secure the necessary resources by means of taxation. It dare not tell the people the truth. The state-socialist principle of running the railways as a state institution would soon lose its popularity if it was proposed, say, to levy a special tax for covering their running losses. And the German and Austrian people would have been quicker in realizing where the resources came from that made bread cheaper if they themselves had had to supply them in the form of a bread tax. In the same way, the German government that decided for the “policy of fulfillment” in opposition to the majority of the German people, was unable to provide itself with the necessary means except by printing notes. And when passive resistance in the Ruhr district gave rise to a need for enormous sums of money, these, again for political reasons, were only to be procured with the help of the printing press.

A government always finds itself obliged to resort to inflationary measures when it cannot negotiate loans and dare not levy taxes, because it has reason to fear that it will forfeit approval of the policy it is following if it reveals too soon the financial and general economic consequences of that policy. Thus inflation becomes the most important psychological resource of any economic policy whose consequences have to be concealed; and so in this sense it can be called an instrument of unpopular, that is, of antidemocratic, policy, since by misleading public opinion it makes possible the continued existence of a system of government that would have no hope of the consent of the people if the circumstances were clearly laid before them. That is the political function of inflation. It explains why inflation has always been an important resource of policies of war and revolution and why we also find it in the service of socialism. When governments do not think it necessary to accommodate their expenditure to their revenue and arrogate to themselves the right of making up the deficit by issuing notes, their ideology is merely a disguised absolutism. 

—Ludwig von Mises, The Theory of Money and Credit, trans. H. E. Batson (Indianapolis: Liberty Fund, 1981), 254-255.