Sidney and Beatrice Webb Praised the “Cult of Science” of the Soviet Union and Hoped that Scientific Planning Would Save Britain from the Depression

Thus in their two volume work Soviet Communism: A New Civilization? Fabian socialists Sidney and Beatrice Webb praised the “Cult of Science” that they had discovered on their visits to the Soviet Union, and held out the hope that scientific planning on a massive scale was the appropriate medicine to aid Britain in its recovery from the depression. The sociologist Karl Mannheim, who fled Frankfurt in 1933 and ultimately gained a position on the LSE faculty, warned that only by adopting a comprehensive system of economic planning could Britain avoid the fate of central Europe. For Mannheim, planning was inevitable; the only question was whether it was going to be totalitarian or democratic. These economists were joined by other highly respected public intellectuals, from natural scientists to politicians.

If planning was the word on everyone’s lips, very few were clear about exactly what it was to entail. The situation was well captured by Hayek’s friend and LSE colleague Lionel Robbins, who in 1937 wrote:

“Planning” is the grand panacea of our age. But unfortunately its meaning is highly ambiguous. In popular discussion it stands for almost any policy which it is wished to present as desirable. . . . When the average citizen, be he Nazi or Communist or Summer School Liberal, warms to the statement that “What the world needs is planning,” what he really feels is that the world needs that which is satisfactory.

—Bruce Caldwell, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 2, The Road to Serfdom: Text and Documents; The Definitive Edition, by F. A. Hayek (Chicago: University of Chicago Press, 2007), 8-9.

If One Cannot Fight the Nazis One Ought at Least Fight the Ideas Which Produce Nazism

The expanded scope and the inherent difficulties of the material covered in the “Scientism” essay were partly responsible for the slowdown, but it was also due to Hayek’s decision to begin focusing on another project. He announced this in his holiday letter to Machlup, begun in December 1940 in Cambridge (where by this time Hayek had, with the assistance of John Maynard Keynes, secured rooms at King’s College) and finished on New Year’s Day 1941 in Tintagel on the Cornish coast: “at the moment I am mainly concerned with an enlarged and somewhat more popular exposition of the theme of my Freedom and the Economic System which, if I finish it, may come out as a sixpence Penguin volume.” By the summer Hayek would report that a “much enlarged” version of the pamphlet was “unfortunately growing into a full fledged book.” Finally, by October 1941 Hayek told Machlup that he had decided to devote nearly all of his time to what would become The Road to Serfdom:

It [the “Scientism” essay] is far advanced, but at the moment I am not even getting on with that because I have decided that the applications of it all to our own time, which should some day form volume II of The Abuse and Decline of Reason, are more important. . . . If one cannot fight the Nazis one ought at least fight the ideas which produce Nazism; and although the well-meaning people who are so dangerous have of course no idea of it, the danger which comes from them is none the less serious. The most dangerous people here are a group of socialist scientists and I am just publishing a special attack on them in Nature—the famous scientific weekly which in recent years has been one of the main advocates of “planning.”

Hayek’s change in course is understandable. He had begun his great book just as Europe was going to war. Western civilisation itself was at stake, and given that the British government would not allow him to participate directly, writing a treatise on how the world had come to such an awful state was to be Hayek’s war effort, the best he could do “for the future of mankind.” Two years later the prospects for the allies seemed brighter, but a new danger was looming. Hayek increasingly feared that the popular enthusiasm for planning, one that had only increased during the war, would affect postwar policy in England. The Road to Serfdom was intended as a counterweight to these trends. Working on it became his first priority, even if it meant delaying his more scholarly treatment of the historical origins and eventual spread of the doctrines that had in his estimation led to the abuse and decline of reason.

—Bruce Caldwell, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 13, Studies on the Abuse and Decline of Reason: Text and Documents, by F. A. Hayek (Chicago: University of Chicago Press, 2010), 6-8.

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

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

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

N. Scott Arnold Demonstrates that Market Socialist Models Possess Systematic Exploitation, NOT the Classic Capitalist Firm

 N. Scott Arnold’s book does not address the history of real existing socialism and the disappointment of these regimes to deliver on their revolutionary promise. This is a work in political, philosophical and economic appraisal of the model of market socialism as offered by the leading theoretical proponents of that system. The economic framework employed to critically assess the model of market socialism is one of the new institutional economics, with a special emphasis on the work on the theory of the firm and contracting (as represented in the work of Coase, Alchian, Demsetz, Williamson and Milgrom and Roberts, but also including an examination of the political process and bureaucracy (as represented in the work of Terry Moe). This makes perfect sense because the focus of the study is on the market socialist claim that workers’ control systems can eliminate the exploitation endemic to capitalist production. What Arnold demonstrates is that it is market socialist models that possess systematic exploitation, not the classic capitalist firm. The well-known concept of opportunism in the new institutionalist literature is employed here to show that it is cooperatives that offer numerable opportunities for opportunism, while the classic capitalist firm has found ways to police this problem.

—Peter J. Boettke, review of The Philosophy and Economics of Market Socialism: A Critical Study, by N. Scott Arnold, Public Choice 91, nos. 3-4 (June 1997): 417-418.

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

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

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

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

The Subject of the Thesis for Hayek’s Second Doctorate Degree Was the Theory of the Imputation of Value

The subject matter was a complete departure from his preparatory studies at the University of Vienna, where the subject of the thesis for his second doctorate degree was the theory of Zurechnung, the imputation of value. His approach to economics was firmly rooted in the Austrian tradition of the subjective theory of value and marginal utility, where the value of any good was derived from the necessarily subjective demand of individuals. But, as Hayek wrote in an essay published in 1926, “The doctrine of marginal utility makes it possible to equate the subjective value of economic goods with a certain level of utility yielded by them if the good yields this utility directly and in isolation. . . . However, this principle is not immediately applicable to those goods which cannot by themselves satisfy certain needs and wants but which are able to do so only in combination with other economic goods. . . . [T]he problem of the derivation of the value of the individual producer goods from the jointly produced level of utility has entered into the economic literature under the name of Zurechnung (in English, imputation). . . .” And not to underestimate the difficulty, Hayek announces, “Consequently, the whole of economic theory rests on the explanation of the value of producer goods and thus on the theory of imputation.” It is not then surprising that Hayek consistently finds the consequences of monetary imbalances in adverse changes in the relative prices of producer and consumer goods.

—Stephen Kresge, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 5, Good Money, Part I: The New World, by F. A. Hayek (Indianapolis: Liberty Fund, 1999), 5.

It Is the Delay in this Adaptation of the Economy Due to Wage and Price Rigidities that Gives Rise to Secondary Deflation

Having thus disposed of the necessity of deflation, how then did, in Hayek’s view, a secondary deflation develop and what would have been an adequate policy response to it? Here the crucial element is the existence of wage and price rigidities:

There can be little question that these rigidities tend to delay the process of adaptation and that this will cause a ‘secondary’ deflation which at first will intensify the depression but ultimately will help to overcome these rigidities. 

From this passage (and similar ones) we can conclude that the remedying effect of the (primary) depression could be successfully fulfilled, were it not for the obstacle of rigid wages and prices. In turn, it is the delay in this adaptation of the economy due to rigidities that gives rise to secondary deflation. 

—Hansjoerg Klausinger, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 8, Business Cycles, Part II, by F. A. Hayek (Carmel, IN: Liberty Fund, 2017), 9-10.

The Depression Represents an Adjustment Process; This Process Can, BUT NEED NOT, Be Accompanied by Deflation

Just at the time when Hayek had entered the scene as an economic theorist in Great Britain, the economies of the major industrial countries found themselves in the midst of what came to be known as the Great Depression, characterised by a slump in production, high rates of unemployment, and a all in prices accompanied by a shrinking circulation of money. As soon as the fall in prices made itself felt, a debate on the proper reaction in terms of monetary policy evolved, in particular on whether the authorities should respond with expansionist policies and relation. Indeed, policies for preventing and counteracting deflation appeared to follow from Hayek’s stance, too, as neutral money to a first approximation corresponded to a policy of stabilising monetary circulation. Yet, as is well known, Hayek—like most of the economists close to the Austrian school—refrained from any such proposals and was extremely cautious with regard to expansionist monetary policies. Therefore a crucial question to be addressed is how Hayek conceived of the phenomenon of deflation and why he remained so hostile to anti-deflation policies.

In order to answer this question it is necessary to reconstruct Hayek’s approach to deflation. To recapitulate, according to Hayek’s theory the crisis is caused by a maladjustment in the structure of production typically initiated by a credit boom, such that the period of production (representing the capitalistic structure of production) is lengthened beyond what can be sustained by the rate of voluntary savings. The necessary reallocation of resources and its consequences give rise to crisis and depression. Thus, the ‘primary’ cause of the crisis is a kind of ‘capital scarcity’ while the depression represents an adjustment process by which the capital structure is adapted. This process can, but need not, be accompanied by deflation. It is in this specific meaning that Hayek speaks of deflation as being ‘secondary’, for example, when referring to “these (in a methodological sense) secondary complications which arise during the depression”, or maintains that “the process of deflation represents only a secondary phenomenon”. It should also be clear that Hayek was propounding the definition of deflation then prevailing in Austrian circles, that is, deflation as a decrease in (the circulation of) money as opposed to the more common meaning of a decrease in prices (or the price level).

—Hansjoerg Klausinger, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 8, Business Cycles, Part II, by F. A. Hayek (Carmel, IN: Liberty Fund, 2017), 5-6.

According to Hayek and the Austrians a RELATIVE INFLATION Characterised the American Boom of the 1920s, Especially after 1927

The distinction between Hayek’s emphasis on relative prices and the preoccupation of the ‘stabilisation theorists’ with the price level is brought out most clearly when considering a steadily progressive economy. Here, unlike the stationary economy, the output (of consumers’ goods) is growing over time, in the simplest case due to technical progress that steadily increases the total productivity of the factors of production. Then a constant circulation of money makes the price level decline inversely to the rate of productivity growth. In fact, advocacy of such a ‘productivity norm’ for price-level behaviour was not novel. As pointed out by Robbins, such was “not the esoteric creed of a handful of ‘sadistic deflationists’”, but the opinion of many economists of repute like Marshall, Edgeworth, Taussig, Hawtrey, Robertson, and Pigou. Yet, it was Hayek’s major and novel contribution to argue for this norm as a requirement of neutrality and thus as a means to prevent the trade cycle, whereas the older economists often had rested their case on considerations of equity. 

Looking at the market for loanable funds, in order to keep prices stable in the face of growing output money must be injected into the circulation. In particular, when money is injected by credit creation this constitutes an additional supply of credit beyond that of voluntary saving, and for this additional supply to be absorbed by demand, the interest rate must fall below its equilibrium level. Yet, this is just the situation that will give rise to an unsustainable boom, and thus to the trade cycle. In the terminology of Haberler’s study this case is one of ‘relative inflation’. According to Hayek and the Austrians such a relative inflation characterised the American boom of the 1920s, especially after 1927, and consequently the stabilisation of the price level in the face of buoyant growth in productivity was to blame for causing the crisis of 1929 and eventually the Great Depression.

—Hansjoerg Klausinger, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 7, Business Cycles, Part I, by F. A. Hayek (Carmel, IN: Liberty Fund, 2017), 35-36.

The Cherished Economic Theories Adopted and Applied Since the 1930s Are Tragically and Fundamentally Incorrect

 The current inflationary depression [1974-1975] has revealed starkly to the nation’s economists that their cherished theories—adopted and applied since the 1930s—are tragically and fundamentally incorrect. For forty years we have been told, in the textbooks, the economic journals, and the pronouncements of our government’s economic advisors, that the government has the tools with which it can easily abolish inflation or recession. We have been told that by juggling fiscal and monetary policy, the government can “fine-tune” the economy to abolish the business cycle and insure permanent prosperity without inflation. Essentially—and stripped of the jargon, the equations, and the graphs—the economic Establishment held all during this period that if the economy is seen to be sliding into recession, the government need only step on the fiscal and monetary gas—to pump in money and spending into the economy—in order to eliminate recession. And, on the contrary, if the economy was becoming inflationary, all the government need do is to step on the fiscal and monetary brake—take money and spending out of the economy—in order to eliminate inflation. In this way, the government’s economic planners would be able to steer the economy on a precise and careful course between the opposing evils of unemployment and recession on the one hand, and inflation on the other. But what can the government do, what does conventional economic theory tell us, if the economy is suffering a severe inflation and depression at the same time? Now can our self-appointed driver, Big Government, step on the gas and on the brake at one and the same time?

—Murray N. Rothbard, introduction to the 3nd edition of America’s Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2008), xxv-xxvi.

While Monetarists and Austrians Both Focus on the Role of Money in the Great Depression, the Causal Emphases and Policy Conclusions Are Diametrically OPPOSED

 Furthermore, as in the case of Fisher and Hawtrey, the current monetarists uphold as an ethical and economic ideal the maintenance of a stable, constant price level. The essence of the cycle is supposed to be the rise and fall—the movements—of the price level. Since this level is determined by monetary forces, the monetarists hold that if the price level is kept constant by government policy, the business cycle will disappear. Friedman, for example, in his A Monetary History of the United States, 1867-1960 (1963), emulates his mentors in lauding Benjamin Strong for keeping the wholesale price level stable during the 1920s. To the monetarists, the inflation of money and bank credit engineered by Strong led to no ill effects, no cycle of boom and bust; on the contrary, the Great Depression was caused by the tight money policy that ensued after Strong’s death. Thus, while the Fisher-Chicago monetarists and the Austrians both focus on the vital role of money in the Great Depression as in other business cycles, the causal emphases and policy conclusions are diametrically opposed. 

To the Austrians, the monetary inflation of the 1920s set the stage inevitably for the depression, a depression which was further aggravated (and unsound investments maintained) by the Federal Reserve efforts to inflate further during the 1930s. The Chicagoans, on the other hand, seeing no causal factors at work generating recession out of preceding boom, hail the policy of the 1920s in keeping the price level stable and believe that the depression could have been quickly cured if only the Federal Reserve had inflated far more intensively during the depression.

—Murray N. Rothbard, introduction to the 2nd edition of America’s Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2008), xxxiii-xxxiv.

The Chicago Approach to the Business Cycle Is No More Than a Recrudescence of the Fisher-Hawtrey Purely Monetary Theory of the 1910s and 1920s

Along with the renewed emphasis on business cycles, the late 1960s saw the emergence of the  “monetarist” Chicago School, headed by Milton Friedman, as a significant competitor to the Keynesian emphasis on compensatory fiscal policy. While the Chicago approach provides a welcome return to the pre-Keynesian emphasis on the crucial role of money in business cycles, it is essentially no more than a recrudescence of the “purely monetary” theory of Irving Fisher and Sir Ralph Hawtrey during the 1910s and 1920s. Following the manner of the English classical economists of the nineteenth century, the monetarists rigidly separate the “price level” from the movement of individual prices; monetary forces supposedly determine the former while supply and demand for particular goods determine the latter. Hence, for the monetarists, monetary forces have no significant or systematic effect on the behavior of relative prices or in distorting the structure of production. Thus, while the monetarists see that a rise in the supply of money and credit will tend to raise the level of general prices, they ignore the fact that a recession is then required to eliminate the distortions and unsound investments of the preceding boom. Consequently, the monetarists have no causal theory of the business cycle; each stage of the cycle becomes an event unrelated to the following stage.

—Murray N. Rothbard, introduction to the 2nd edition of America’s Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2008), xxxii-xxxiii.

The Currency Is VIRTUALLY FIAT in Both the Gold Bullion and the Gold Exchange Standards (the Standards Used in the 1920s)

The nobility of the American aim to help Europe return to the gold standard becomes even more questionable when we realize that Europe never did return to a full gold standard. Instead, it adopted a “gold bullion” standard, which prohibited gold coinage, thus restricting gold convertibility to heavy bars suitable only for large international transactions. Often it chose a “gold exchange” standard, under which a nation keeps its reserves not in gold but in a “hard” currency like dollars. It then redeems its units only in the other country’s harder currency. Clearly, this system permits an international “pyramiding” of inflation on the world’s given stock of gold. In both the gold bullion and the gold exchange standards, the currency is virtually fiat, since the people are de facto prohibited from using gold as their medium of exchange. The use of the term “gold standard” by foreign governments in the 1920s, then, was more of a deception than anything else. It was an attempt to draw to the government the prestige of being on the gold standard, while actually failing to abide by the limitations and requirements of that standard. Great Britain, in the late 1920s, was on a gold bullion standard, and most other “gold standard countries” were on the gold exchange standard, keeping their titles to gold in London or New York. The British position, in turn, depended on American resources and lines of credit, since only America was on a true gold standard.

—Murray N. Rothbard, America’s Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2008), 148-149.

The Boom CANNOT Continue Indefinitely; The Public Awakens to the Policy of Permanent Inflation and Flees from Money into Goods

It might be objected that depression only began when credit expansion ceased. Why shouldn’t the government continue credit expansion indefinitely? In the first place, the longer the inflationary boom continues, the more painful and severe will be the necessary adjustment process. Second, the boom cannot continue indefinitely, because eventually the public awakens to the governmental policy of permanent inflation, and flees from money into goods, making its purchases while the dollar is worth more than it will be in future. The result will be a “runaway” or hyperinflation, so familiar to history, and particularly to the modern world. Hyperinflation, on any count, is far worse than any depression: it destroys the currency—the lifeblood of the economy; it ruins and shatters the middle class and all “fixed income groups”; it wreaks havoc unbounded. And furthermore, it leads finally to unemployment and lower living standards, since there is little point in working when earned income depreciates by the hour. More time is spent hunting goods to buy. To avoid such a calamity, then, credit expansion must stop sometime, and this will bring a depression into being.

—Murray N. Rothbard, America’s Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2008), 23.

One Can NEVER Understand the Operation of a Private Property Society IF One Thinks in Terms of the TOTALITY of a Society’s Economy

The old tendency, taken over from the Cameralists, to base the analysis of economic problems of the “national economy,” on the “totality” and not on the acting human subjects, seems hard to eradicate. In spite of all the warnings of the subjective economists, we continue to observe relapses. It is one of the lesser evils that ethical judgments regarding phenomena are presented under the guise of scientific objectivity. For example, productive activity (i.e., activity carried out in an imagined socialist community led by the critic) is contrasted with profit-seeking activity (i.e., the activity of individuals in a society based on private property in the means of production). The former will be viewed as the “just” and the latter as the “unjust” mode of production. Much more important is the fact that if one thinks in terms of the totality of a society’s economy, one can never understand the operation of a society based on private property in the means of production. It is erroneous to maintain that the necessity for the collectivist method can be proved by showing that actions of the individuals can only be understood within the framework of that individual’s environment. This is so because economic analysis does not depend on the psychological understanding of the motives of action, but only an understanding of action itself. It is unimportant for catallactics why bread, clothes, books, cannons or religious items are desired on the market; it is only important that a certain demand does exist. The mechanism of the market and, therefore, the laws of the capitalistic economy can only be grasped if one begins with the forces operating on the market. But on the market there are only individuals acting as buyers and sellers, never the “totality.” In economic theory, the totality can be taken only in the sense of an economic collective where the means of production are entirely outside the orbit of exchange and, therefore, cannot be sold for money. Here there is neither room for price theory nor a theory of money. But if we wish to grasp the value problems of a collective economy, we can  — ironically — only use that method of analysis which has come to be known as the “individualistic method.”

—Ludwig von Mises, “The Position of Money among Economic Goods,” in Money, Method, and the Market Process: Essays by Ludwig von Mises, ed. Richard M. Ebeling (Norwell, MA: Kluwer Academic Publishers, 1990), 60-61.

The Austrian Theory of the Business Cycle Is a MICROECONOMIC PROCESS as the Price of Time Is Severed from the Preferences that Underlie It

It is the unobservability of the natural rate that is central to understanding the Austrian theory of the business cycle. Because the natural rate of interest is a theoretical construct and not a phenomenon observable on any real market, we cannot know with certainty that any given market rate of interest is accurately reflecting the underlying natural rate. It is in this sense that the Austrian theory of the business cycle is ultimately a microeconomic process; the problem begins with a price that becomes severed from the preferences that are supposed to underlie it. The whole theory elaborates the microeconomic results of that mistaken price signal. Because the price in question is the price of time, and all economic production involves time, the effects of that erroneous price are much more pervasive than those of any other price. It is that pervasiveness that makes the Austrian cycle theory ‘macroeconomic.’ It is not, however, macroeconomic in the sense of explaining some relationship among aggregates. This confusion arises with some frequency, especially when the theory is referred to as an overinvestment theory. The problem is not that there is too much investment (per se) but that the wrong kind of investment is taking place. That distinction is not readily visible through the eyes of modern macroeconomics since Keynes, which has understood investment only in terms of some aggregate measure rather than as part of an interconnected capital structure where the composition of investment is just as important as its overall level.

—Steven Horwitz, Microfoundations and Macroeconomics: An Austrian Perspective, Foundations of the Market Economy (London: Taylor & Francis e-Library, 2003), 126.

IS-LM Analysis Is Unable to Handle the EX ANTE Situation with Investment NOT Equal to Savings

The fundamental problem with the IS curve is that the equilibrium condition that defines the curve ignores the crucial difference between ex ante and ex post savings and investment. Ex post investment always equals savings, i.e., if investment is taking place, the savings must have come from somewhere. However, investment and savings need not be equal ex ante, and this is the point that IS-LM analysis is unable to handle. If the market rate of interest is inconsistent with the underlying preferences of savers and investors, then ex ante savings and investment may not be equal, triggering system-wide changes in prices and resource allocation, including labor. The whole Wicksellian / monetary equilibrium tradition we shall explore is centered around the way that market forces attempt to correct ex ante disequilibria, and the patterns of discoordination that such attempts can engender. For Wicksellians, it is ex ante disequilibria in the loanable funds market that explain movements in the price level and the resulting economic discoordination. However, by not addressing the possibility of ex ante disequilibrium, the IS-LM mechanism, and Keynes of The General Theory, overlook the entire set of problems that interest a post-Wicksellian, and to that extent Austrian, macroeconomist. 

—Steven Horwitz, introduction to Microfoundations and Macroeconomics: An Austrian Perspective, Foundations of the Market Economy (London: Taylor & Francis e-Library, 2003), 8-9.

Forced Saving Occurs When Investment Expenditure Is Financed by Monetary Expansion

 According to Keynes, fiscal expansion would increase the price of ‘wage goods’ (that is, consumer goods) as a result of diminishing returns. This would simultaneously reduce real wages and increase profitability. Yet the concept of ‘forced saving’ was denied. Forced saving occurs when investment expenditure is financed by monetary expansion: as resources are reallocated to the production of capital goods, fewer commodities are available to consumers, and so forced saving takes place. Forced saving provided a key element in the Loanable Funds theory of interest rate determination. Later attempts to reconcile the Loanable Funds theory with Keynes’s Liquidity Preference theory are critically examined, and the latter is judged to be an unwarranted generalisation based upon very special circumstances.

—G. R. Steele, introduction to Monetarism and the Demise of Keynesian Economics (New York: St. Martin’s Press, 1989), 4.

The Interest Rate Is a Function of the Supply and Demand for Loanable Funds

The business cycle is caused by the changes in the money supply that affect relative prices, and most importantly, the interest rate. One might consider why investors do not perceive these misleading price signals, and the reason is that individuals are not in a good position to separate out changes in prices due to changes in underlying supply and demand conditions from changes in prices due to monetary factors. In addition to the inevitable uncertainty about the future that has already been noted, as economic progress occurs, people may change their time preference. Increasing incomes can lead individuals to defer some consumption until later, saving more and consuming less in the present. This would increase the supply of loanable funds and lower the interest rate as a result of real changes in preferences rather than changes induced by monetary factors. Savers and investors can respond to market signals, but do not have a good way of separating interest rate changes caused by changes in time preference from changes due to monetary fluctuations. 

Garrison (2001) discusses changes in the interest rate that might be due to technological advances. If a new technology is developed for producing consumer goods, that technology might require investment in the short term to produce the goods that are anticipated to be profitable in the long run. An increase in investment demand will cause the interest rate to rise in the short run, but that short run might be a period of years before the technology is finally in place and able to deliver the consumer goods. This is an example with the larger point being that the interest rate is a function of the supply and demand for loanable funds. Many factors influence the supply and demand for loanable funds, and the effect of monetary expansion and contraction on the supply of loanable funds is only one factor. Entrepreneurs will, of course, try to discern and separate monetary causes for fluctuations in the interest rate from other causes, but in a complex economy nobody can do this perfectly. Market participants can see the actual market rate but can only conjecture about the importance of various factors that cause that rate to be at its current level. 

—Randall G. Holcombe, Advanced Introduction to the Austrian School of Economics, Elgar Advanced Introductions (Cheltenham, UK: Edward Elgar Publishing, 2014), 80-81. 

Non-Austrian Views of the Business Cycle View a Booming Economy as a Healthy One

Rothbard (1963), taking an Austrian school approach, describes the cause of the Great Depression as the result of malinvestment that occurred during the 1920s. Monetary expansion during the 1920s led to the boom period described by Mises and Hayek. The Keynesian explanation for the Depression is that aggregate demand declined, largely due to the volatility of investment demand that suffered a substantial reduction after the stock market crash of 1929. The monetarist explanation was that because of problems with the banking system, the money supply declined precipitously following the 1929 stock market crash, and that monetary contraction turned what would have been a much less severe recession into the Great Depression. 

The Austrian explanation distinguishes itself by tracing the causal factors back to malinvestment during the upturn in the cycle. The problems leading to the business cycle occur during the upturn, and the downturn is the recovery phase, during which dislocations occur as people reallocate their resources away from unsustainable uses, as Horwitz (2000) notes. The significance of malinvestment as a cause of the downturn naturally focuses attention on the importance of recognizing the heterogeneity of capital. The Keynesian, monetarist and more recent general equilibrium models of the business cycle do not see the causes as being created by malinvestment prior to the downturn because those models do not account for the heterogeneity of capital. Non-Austrian views of the business cycle view a booming economy as a healthy one, whereas the Austrian school sees the downturn as the inevitable consequence of malinvestment during the boom phase.

—Randall G. Holcombe, Advanced Introduction to the Austrian School of Economics, Elgar Advanced Introductions (Cheltenham, UK: Edward Elgar Publishing, 2014), 80. 

Coase’s Transaction-Cost Theory of the Firm Can Be Interpreted as Attempting to Strengthen the Argument for Market Socialism

 Instead, however, Coase chooses a very different approach, in which the market’s resource allocation, in accordance with Salter’s and Plant’s teachings, is efficient but in which it appears costly to use the price mechanism. Doing this, Coase formulates an argument that seems intended to undermine Mises’s case for free-market resource allocation by showing that the cost of using the price mechanism makes it imperfect (costly) for coordinating production. While the allocative result of the price mechanism may be superior (even with transaction costs), this is insufficient, since the assumption often made in economic theory—that prices are known—“is clearly not true of the real world.” This identification is well in line with Coase’s lifelong contribution to economic research, which has been dedicated to “the study of the working of the real world economic system.”

The ‘costly market’ approach plays well into the market socialists’ argumentation for the possibility of socialism, as discussed above, and their proposed schemes to overcome Mises’s calculation problem by providing socialism with centrally regulated, advertised (therefore easily known) list prices. Coase's transaction-cost theory of the firm can, in this sense, be interpreted as attempting to undermine the theory of capitalism and, at the same time, strengthen the argument for market socialism.

Really, Coase’s argument essentially echoes that of Taylor (1929): socialism (or the firm) can be as efficient as capitalism, yet have the benefit of being less costly. Coase’s concurrent work on accounting appears to strengthen this interpretation.

—Per L. Bylund, “Ronald Coase’s ‘Nature of the Firm’ and the Argument for Economic Planning,” Journal of the History of Economic Thought 36, no. 3 (September 2014): 320-321.

Although Taken for Granted, the Business Firm as an Economic Phenomenon Is One of the Most Complicated to Explain

 It may not be much of an exaggeration to claim that many of science’s great achievements have been of one of two kinds: it has shown that what was believed to be impossibly complex is in fact the result of a rather simple mechanism or process; and it has shown that what was thought of as simple or taken for granted was in fact quite complicated or even beyond our ability to explain. In line with the latter, it indeed seems often to be the case that what appears to be most glaringly obvious may sometimes be the very hardest to explain. The business firm as an economic phenomenon clearly falls in this category. 

To the non-academic, the firm presents little problem. Perhaps this is the reason why it was taken for granted for so long also in the study of economics. While the firm has often been present in different forms of analyses and theorising, it has far less often been subject to scrutiny. Adam Smith famously discusses the division of labour exemplified by work with a pin factory and Karl Marx similarly discusses the use and exploitation of labour within factories, to mention only two noteworthy examples. Yet neither of them ask the fundamental question of why there are firms. This, in fact, is almost exclusively the case for economists and social theorists for all but the last century. If the modern account of the recent history of economics is to be trusted, this question remained unasked until a very young Ronald H. Coase posed it in his Nobel-winning article ‘The Nature of the Firm’ published in 1937. Coase’s article was not the first to study firms, but it is generally regarded as the beginning of the modern theory of the firm literature — the tradition that asks why there are firms.

—Per L. Bylund, introduction to The Problem of Production: A New Theory of the Firm, Routledge Advances in Heterodox Economics 27 (London: Routledge Taylor and Francis Group, 2016), 1.

The Ergodic Presumption Is the Essential Foundation of Classical Efficient Market Theory

To grasp Keynes’s theory, one must first consider the contrasting framework, accepted down to our day by most economists, which Keynes rejected. In that view, everything is fine as long as prices and wages are flexible. If prices can adjust to changes in business expectations, why should there ever be a serious problem? Davidson contends that this way of thinking rests on a flawed assumption. Advocates of the standard model imagine that accurate markets exist, not only for present transactions, but for future contracts as well.

The assumption of accurate futures markets in turn rests on a hypothesis, which Davidson deems the crucial principle of neoclassical economics.

Since drawing a sample from the future is not possible, efficient market theorists presume that probabilities calculated from already existing past and current market data are equivalent to drawing a sample from markets that will exist in the future . . . the presumption that data samples from the past are equivalent to data samples from the future is called the ergodic axiom. Those who invoke this ergodic assertion argue that economics can be a “hard science” like physics or astronomy only if the ergodic axiom is part of the economist’s model. . . . The ergodic presumption is the essential foundation of classical efficient market theory.

Readers will not be surprised to learn that Samuelson, who evidently ranks high on the list of Davidson ’s villains, fervently endorses the ergodic axiom. 

Keynes saw the fallacy in this assumption. The future is in fact radically uncertain.

The classical ergodic axiom, which assumes that the future is known and can be calculated as the statistical shadow of the past, was one of the most important classical assumptions that Keynes rejected. . . . For decisions that involved potential large spending outflows or possible large income inflows that span a significant length of time, [Keynes argued that] people “know” that they do not know what the future will be. They do know that for these important decisions, making a mistake about the future can be very costly . . . 

Keynes, the author of A Treatise on Probability, was well equipped to make this fundamental point. 

Davidson is right that Keynes has here scored heavily against neoclassical economics. But the uncertainty of the future hardly suffices to establish the validity of the Keynesian system. For one thing, Austrian economics also emphasizes the uncertainty of the future. It is constantly stressed by Mises, who goes so far as to claim that the uncertainty of the future is a praxeological law, deduced from the action axiom. Davidson never so much as mentions the Austrian School in this book. For him, only the efficient-market economists, with their false ergodic assumption, and their Keynesian rivals count.  

—David Gordon, review of The Keynes Solution: The Path to Global Economic Prosperity, by Paul Davidson, The Mises Review 15, no. 3 (Fall 2009), under “The Discussion of Chapter 19 of the General Theory,” https://mises.org/library/keynes-solution-path-global-economic-prosperity-paul-davidson (accessed May 12, 2021).

Hayek Attempts to Resolve the Dilemma between Equilibrium Theory and the Disequilibrium Associated with Business Cycles

In Monetary Theory and the Trade Cycle, Hayek draws attention to the deficiency of equilibrium theory to explain “why a general disproportionality between supply and demand should arise.” The solution to this problem, Hayek notes, is not to be found by changes originating within the equilibrium construct nor by the methods of equilibrium analysis since “the essential means of explanation in static theory . . . is the assumption that prices supply an automatic mechanism for equilibrating supply and demand.” In resolving the dilemma between equilibrium theory and the disequilibrium associated with business cycles, Hayek argues that it is only the introduction of money that can provide a “new determining cause” capable of explaining “the difference between the course of events described by static theory . . . and the actual course of events.” The introduction of money, Hayek tells us, “does away with the rigid interdependence and self-sufficiency of the ‘closed’ system of equilibrium and makes possible movements which would be excluded from the latter.” . . . 

My remarks perhaps come in somewhat sharper relief if we examine Hayek’s discussion of neutral money in the Appendix to Lecture IV of Prices and Production. In general, neutral money is employed by Hayek to describe a monetary economy that has achieved a constellation of relative prices as if money were not present; it would involve an economy fully specifiable by equilibrium theory. In reflecting on the suitability of the neutral money concept as an objective of monetary policy, Hayek says:

. . . the term points, of course, only to a problem, and does not represent a solution. . . . The necessary starting point for any attempt to answer the theoretical problem seems to me to be the recognition of the fact that the identity of demand and supply, which must necessarily exist in the case of barter, ceases to exist as soon as money becomes the intermediary of the exchange transaction. The problem then becomes one of isolating the one-sided effects of money . . . which will appear when, after the division of the barter transaction into separate transactions, one of these takes place without the other complementary transaction. In this sense, demand without corresponding supply, and supply without a corresponding demand, evidently seem to occur. . . . 

—William N. Butos, “Hayek and General Equilibrium Analysis,” Southern Economic Journal 52, no. 2 (October 1985): 338.

Philosophically, Friedmanism Would Destroy Money Itself and Reduce Us to the Chaos and Primitivism of the Barter System

There is no question about the fact that the present international monetary system is an irrational and abortive monstrosity, and needs drastic reform. But Friedman’s proposed reform, of cutting all ties with gold, would make matters far worse, for it would leave everyone at the complete mercy of his own fiat-issuing state. We need to move precisely in the opposite direction: to an international gold standard that would restore commodity money everywhere and get all the money-manipulating states off the backs of the peoples of the world. 

Furthermore, gold, or some other commodity, is vital for providing an international money—a basic money in which all nations can trade and settle their accounts. The philosophical absurdity of the Friedmanite plan of each government providing its own fiat money, cut loose from all others, can be seen clearly if we consider what would happen if every region, every province, every state, nay every borough, county, town village, block, house, or individual would issue its own money, and we then had, as Friedman envisions, freely fluctuating exchange rates between all these millions of currencies. The ensuing chaos would stem from the destruction of the very concept of money—the entity that serves as a general medium for all exchanges on the market. Philosophically, Friedmanism would destroy money itself, and reduce us to the chaos and primitivism of the barter system. 

One of Friedman’s crucial errors in his plan of turning all monetary power over to the State is that he fails to understand that this scheme would be inherently inflationary. For the State would then have in its complete power the issuance of as great a supply of money as it desired. Friedman’s advice to restrict this power to an expansion of 3–4% per year ignores the crucial fact that any group, coming into the possession of the absolute power to “print money,” will tend to . . . print it!

 —Murray N. Rothbard, “Milton Friedman Unraveled,” Journal of Libertarian Studies 16, no. 4 (Fall 2002): 50.