What Will Happen to the Pure Interest Rate If People Were Certain that the World Would End in the Near Future?

There are other elements that enter into the determination of the time-preference schedules. Suppose, for example, that people were certain that the world would end on a definite date in the near future. What would happen to time preferences and to the rate of interest? Men would then stop providing for future needs and stop investing in all processes of production longer than the shortest. Future goods would become almost valueless compared to present goods, time preferences for present goods would zoom, and the pure interest rate would rise almost to infinity. On the other hand, if people all became immortal and healthy as a result of the discovery of some new drug, time preferences would tend to be very much lower, there would be a great increase in investment, and the pure rate of interest would fall sharply.

—Murray N. Rothbard, Man, Economy, and State with Power and Market, 2nd ed. of the Scholar’s ed. (Auburn, AL: Ludwig von Mises Institute, 2009), 444.

The Final Market Rates of Interest Reflect the PURE Interest Rate PLUS OR MINUS Entrepreneurial Risk and Purchasing Power Components

In the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time. The “boom-bust” cycle is generated by monetary intervention in the market, specifically bank credit expansion to business. Let us suppose an economy with a given supply of money. Some of the money is spent in consumption; the rest is saved and invested in a mighty structure of capital, in various orders of production. The proportion of consumption to saving or investment is determined by people’s time preferences—the degree to which they prefer present to future satisfactions. The less they prefer them in the present, the lower will their time preference rate be, and the lower therefore will be the pure interest rate, which is determined by the time preferences of the individuals in society. A lower time-preference rate will be reflected in greater proportions of investment to consumption, a lengthening of the structure of production, and a building-up of capital. Higher time preferences, on the other hand, will be reflected in higher pure interest rates and a lower proportion of investment to consumption. The final market rates of interest reflect the pure interest rate plus or minus entrepreneurial risk and purchasing power components. Varying degrees of entrepreneurial risk bring about a structure of interest rates instead of a single uniform one, and purchasing-power components reflect changes in the purchasing power of the dollar, as well as in the specific position of an entrepreneur in relation to price changes. The crucial factor, however, is the pure interest rate. This interest rate first manifests itself in the “natural rate” or what is generally called the going “rate of profit.” This going rate is reflected in the interest rate on the loan market, a rate which is determined by the going profit rate.

—Murray N. Rothbard, America's Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2000), 9-10.

Levying Income Taxes Causes a Shift to a Higher Proportion of Consumption and a Lower Proportion of Saving and Investment

There is another, unheralded reason why an income tax will particularly penalize saving and investment as against consumption. It might be thought that since the income tax confiscates a certain portion of a man’s income and leaves him free to allocate the rest between consumption and investment, and since time preference schedules remain given, the proportion of consumption to saving will remain unchanged. But this ignores the fact that the taxpayer’s real income and the real value of his monetary assets have been lowered by paying the tax. We have seen in chapter 6 that, given a man’s time-preference schedule, the lower the level of his real monetary assets, the higher his time-preference rate will be, and therefore the higher the proportion of his consumption to investment. The taxpayer’s position may be seen in Figure 86, which is essentially the reverse of the individual time-market diagrams in chapter 6. In the present case, money assets are increasing as we go rightward on the horizontal axis, while in chapter 6 money assets were declining. Let us say that the taxpayer’s initial position is a money stock of 0M; tt is his given time-preference curve. His effective time-preference rate, determining his consumption/investment proportion, is t₁. Now, suppose that the government levies an income tax, reducing his initial monetary assets at the start of his spending period to 0M′. His effective time-preference rate, the intersection of tt and the M′ line, is now higher at t₂. He shifts to a higher proportion of consumption and a lower proportion of saving and investment.

—Murray N. Rothbard, Man, Economy, and State with Power and Market, 2nd ed. of the Scholar’s ed. (Auburn, AL: Ludwig von Mises Institute, 2009), 916-917.

It Is Fallacious to Assume that the State Can Simply Add or Subtract Its Expenditures from that of the Private Economy

The breakdown of the economic system into a few aggregates assumes that these aggregates are independent of each other, that they are determined independently and can change independently. This overlooks the great amount of interdependence and interaction among the aggregates. Thus, saving is not independent of investment; most of it, particularly business saving, is made in anticipation of future investment. Therefore, a change in the prospects for profitable investment will have a great influence on the savings function, and hence on the consumption function. Similarly, investment is influenced by the level of income, by the expected course of future income, by anticipated consumption, and by the flow of savings. For example, a fall in savings will mean a cut in the funds available for investment, thus restricting investment.

A further illustration of the fallacy of aggregates is the Keynesian assumption that the State can simply add or subtract its expenditures from that of the private economy. This assumes that private investment decisions remain constant, unaffected by government deficits or surpluses. There is no basis whatsoever for this assumption. In addition, progressive income taxation, which is designed to encourage consumption, is assumed to have no effect on private investment. This cannot be true, since, as we have already noted, a restriction of savings will reduce investment.

Thus, aggregative economics is a drastic misrepresentation of reality. The aggregates are merely an arithmetic cloak over the real world, where multitudes of firms and individuals react and interact in a highly complex manner. The alleged “basic determinants” of the Keynesian system are themselves determined by complex interactions within and between these aggregates.

—Murray N. Rothbard, “Spotlight on Keynesian Economics,” in Strictly Confidential: The Private Volker Fund Memos of Murray N. Rothbard, ed. David Gordon (Auburn, AL: Ludwig von Mises Institute, 2010), 233-234.

The "Cyclically Balanced Budget" Was the First Keynesian Concept to be Poured Down the Orwellian Memory Hole

Originally, Keynesians vowed that they, too, were in favor of a “balanced budget,” just as much as the fuddy-duddy reactionaries who opposed them. It’s just that they were not, like the fuddy-duddies, tied to the year as an accounting period; they would balance the budget, too, but over the business cycle. Thus, if there are four years of recession followed by four years of boom, the federal deficits during the recession would be compensated for by the surpluses piled up during the boom; over the eight years of cycle, it would all balance out. 

Evidently, the “cyclically balanced budget” was the first Keynesian concept to be poured down the Orwellian memory hold, as it became clear that there weren’t going to be any surpluses, just smaller or larger deficits. A subtle but important corrective came into Keynesianism: larger deficits during recessions, smaller ones during booms. 

—Murray N. Rothbard, “Keynesianism Redux,” The Free Market 7, no. 1 (January 1989): 3.

Government Investment Is a Form of Socialism and Fascism Is Private Ownership Subject to Comprehensive Government Control and Planning

Yes, let the state control investment completely, its amount and rate of return in addition to the rate of interest; then Keynes would allow private individuals to retain formal ownership so that, within the overall matrix of state control and dominion, they could still retain “a wide field for the exercise of private initiative and responsibility.” As Hazlitt puts it,

Investment is a key decision in the operation of any economic system. And government investment is a form of socialism. Only confusion of thought, or deliberate duplicity, would deny this. For socialism, as any dictionary would tell the Keynesians, means the ownership and control of the means of production by government. Under the system proposed by Keynes, the government would control all investment in the means of production and would own the part it had itself directly invested. It is at best mere muddleheadedness, therefore, to present the Keynesian nostrums as a free enterprise or “individualistic” alternative to socialism.

There was a system that had become prominent and fashionable in Europe during the 1920s and 1930s that was precisely marked by this desired Keynesian feature: private ownership, subject to comprehensive government control and planning. This was, of course, fascism.

—Murray N. Rothbard, “Keynes’s Political Economy,” in The Rothbard Reader, ed. Joseph T. Salerno and Matthew McCaffrey (Auburn, AL: Mises Institute, 2016), 202-203.

The State Apparatus, the 4th Class of Society, Is a “Deus Ex Machina” External to the Market Guided by Scientific Philosopher Kings

To develop a way out, Keynes presented a fourth class of society. Unlike the robotic and ignorant consumers, this group is described as full of free will, activism, and knowledge of economic affairs. And unlike the hapless investors, they are not irrational folk, subject to mood swings and animal spirits; on the contrary, they are supremely rational as well as knowledgeable, able to plan best for society in the present as well as in the future. 

This class, this deus ex machina external to the market, is of course the state apparatus, as headed by its natural ruling elite and guided by the modern, scientific version of Platonic philosopher kings. In short, government leaders, guided firmly and wisely by Keynesian economists and social scientists (naturally headed by the great man himself), would save the day. In the politics and sociology of The General Theory, all the threads of Keynes’s life and thought are neatly tied up.

And so the state, led by its Keynesian mentors, is to run the economy, to control the consumers by adjusting taxes and lowering the rate of interest toward zero, and, in particular, to engage in “a somewhat comprehensive socialisation of investment.”

—Murray N. Rothbard, Keynes, the Man (Auburn, AL: Ludwig von Mises Institute, 2010), 50.

Only Continual Doses of New Money on the Credit Market Will Keep the Boom Going and the New Stages Profitable

We have seen that the reversion period is short and that factor incomes increase rather quickly and start restoring the free-market consumption/saving ratios. But why do booms, historically, continue for several years? What delays the reversion process? The answer is that as the boom begins to peter out from an injection of credit expansion, the banks inject a further dose. In short, the only way to avert the onset of the depression-adjustment process is to continue inflating money and credit. For only continual doses of new money on the credit market will keep the boom going and the new stages profitable. Furthermore, only ever increasing doses can step up the boom, can lower interest rates further, and expand the production structure, for as the prices rise, more and more money will be needed to perform the same amount of work. Once the credit expansion stops, the market ratios are reestablished, and the seemingly glorious new investments turn out to be malinvestments, built on a foundation of sand.

—Murray N. Rothbard, Man, Economy, and State with Power and Market, 2nd ed. of the Scholar’s ed. (Auburn, AL: Ludwig von Mises Institute, 2009), 1002.

Keynes Severed the Evident Link Between Savings and Investment, Claiming the Two Are Unrelated

There is a subset of consumers, an eternal problem for mankind: the insufferably bourgeois savers, those who practice the solid puritan virtues of thrift and farsightedness, those whom Keynes, the would-be aristocrat, despised all of his life. All previous economists, certainly including Keynes’s forbears Smith, Ricardo, and Marshall, had lauded thrifty savers as building up long-term capital and therefore as responsible for enormous long-term improvements in consumers’ standard of living. But Keynes, in a feat of prestidigitation, severed the evident link between savings and investment, claiming instead that the two are unrelated.

In fact, he wrote, savings are a drag on the system; they “leak out” of the spending stream, thereby causing recession and unemployment. Hence Keynes, like Mandeville in the early eighteenth century, was able to condemn thrift and savings; he had finally gotten his revenge on the bourgeoisie.

By also severing interest returns from the price of time or from the real economy and by making it only a monetary phenomenon, Keynes was able to advocate, as a linchpin of his basic political program, the “euthanasia of the rentier” class: that is, the state’s expanding the quantity of money enough so as to drive down the rate of interest to zero, thereby at last wiping out the hated creditors. It should be noted that Keynes did not want to wipe out investment: on the contrary, he maintained that savings and investment were separate phenomena. Thus, he could advocate driving down the rate of the interest to zero as a means of maximizing investment while minimizing (if not eradicating) savings.

—Murray N. Rothbard, “Keynes’s Political Economy,” in The Rothbard Reader, ed. Joseph T. Salerno and Matthew McCaffrey (Auburn, AL: Mises Institute, 2016), 199-200.

The Austrian Contribution Was to Posit the Deviation of the Market Rate from the Natural Rate as the CAUSE of the Trade Cycle

The price mechanism, then, coordinates economic activity. In a trade cycle, economic activity somehow becomes uncoordinated. In particular, in the crisis stage of the cycle an overproduction of capital goods exists. As such, any adequate theory of the cycle must explain how this situation of disequilibrium in this specific market arises. What keeps the interest rate from performing its coordinative function? 

Once again Wicksell’s framework proved helpful. Wicksell posited another interest rate, the ‘market rate of interest’. The market rate is influenced by banks’ lending activities and can differ from the natural rate: Specifically, it will fall below the natural rate whenever banks increase the amount of credit. Wicksell used the natural rate / market rate distinction to discuss movements in the general price level. The Austrian contribution was to posit the deviation of the market rate from the natural rate as the cause of the trade cycle. 

—Bruce Caldwell, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 9, Contra Keynes and Cambridge: Essays, Correspondence, by F. A. Hayek (Indianapolis: Liberty Fund, 1995), 15.

The Assumption that Consumption and Investment Move in the SAME Direction Over the Business Cycle Is Fundamental to Keynesian Macroeconomics

Hayek emphasized the trade-off between consumption today and consumption tomorrow (via saving and investment today): “The physical quantity of consumer goods per capita can only be increased by consistently devoting a larger part of productive resources to capitalistic investment rather than to immediate consumption.” One can illustrate the trade-off by drawing a production possibilities frontier between consumption and investment, as Roger Garrison has done in his important work developing Hayekian macroeconomics, particularly in the book Time and Money. Although the trade-off derives directly from the assumption of scarcity, and is today taken for granted by economists in the context of growth theory, Hayek noted that it is implicitly denied by all those economists who “assume that the demand for capital goods changes in proportion to the demand for consumer goods.” The most prominent such economists in 1932 were the “underconsumption” theorists of economic depressions, including John Maynard Keynes in his Treatise on Money  of 1930, which Hayek cited in this connection. Keynes amplified the underconsumption theme in his General Theory of 1936. The assumption that consumption and investment move in the same direction over the business cycle (by contrast to the trade- off acknowledged in the analysis of long-run growth) has been fundamental to Keynesian macroeconomics up to the present day.

—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), xxi.

In Rothbard’s Opinion, Lionel Robbins’s Book Is Unquestionably the BEST Work on the Great Depression

Lionel Robbins’s The Great Depression is one of the great economic works of our time. Its greatness lies not so much in originality of economic thought, as in the application of the best economic thought to the explanation of the cataclysmic phenomena of the Great Depression. This is unquestionably the best work published on the Great Depression.

At the time that Robbins wrote this work, he was perhaps the second most eminent follower of Ludwig von Mises (Hayek being the first). To his work, Robbins brought a clarity and polish of style that I believe to be unequalled among any economists, past or present. Robbins is the premier economic stylist.

In this brief, clear, but extremely meaty book, Robbins sets forth first the Misesian theory of business cycles and then applies it to the events of the 1920s and 1930s. We see how bank credit expansion in the United States, Great Britain, and other countries drove the civilized world into a great depression.⁶²

Then Robbins shows how the various nations took measures to counteract and cushion the depression that could only make it worse: propping up unsound, shaky business positions; inflating credit; expanding public works; keeping up wage rates (e.g., Hoover and his White House conferences)—all things that prolonged the necessary depression adjustments and profoundly aggravated the catastrophe. Robbins is particularly bitter about the wave of tariffs, exchange controls, quotas, etc. that prolonged crises, set nation against nation, and fragmented the international division of labor.

__________
⁶²In Britain the expansion was generated because of the rigid wage structure caused by unions and the unemployment insurance system, as well as a return to the gold standard at too high a par; and in the United States it was generated by a desire to inflate in order to help Britain, as well as an absurd devotion to the ideal of a stable price level.

—Murray N. Rothbard, Strictly Confidential: The Private Volker Fund Memos of Murray N. Rothbard, ed. David Gordon (Auburn, AL: Ludwig von Mises Institute, 2010), 289-290.

According to Rothbard, Sir Ralph George Hawtrey Was One of the Evil Geniuses of the 1920s

Executive director and operating head of the Association with such formidable backing was Norman Lombard, brought in by Fisher in 1926. The Association spread its gospel far and wide. It was helped by the publicity given to Thomas Edison and Henry Ford’s proposal for a “commodity dollar” in 1922 and 1923. Other prominent stabilizationists in this period were professors George F. Warren and Frank Pearson of Cornell, Royal Meeker, Hudson B. Hastings, Alvin Hansen, and Lionel D. Edie. In Europe, in addition to the above mentioned, advocates of stable money included: Professor Arthur C. Pigou, Ralph G. Hawtrey, J.R. Bellerby, R.A. Lehfeldt, G.M. Lewis, Sir Arthur Salter, Knut Wicksell, Gustav Cassel, Arthur Kitson, Sir Frederick Soddy, F.W. Pethick-Lawrence, Reginald McKenna, Sir Basil Blackett, and John Maynard Keynes. Keynes was particularly influential in his propaganda for a “managed currency” and a stabilized price level, as set forth in his A Tract on Monetary Reform, published in 1923.

Ralph Hawtrey proved to be one of the evil geniuses of the 1920s. An influential economist in a land where economists have shaped policy far more influentially than in the United States, Hawtrey, Director of Financial Studies at the British Treasury, advocated international credit control by Central Banks to achieve a stable price level as early as 1913. In 1919, Hawtrey was one of the first to call for the adoption of a gold-exchange standard by European countries, tying it in with international Central Bank cooperation. Hawtrey was one of the prime European trumpeters of the prowess of Governor Benjamin Strong. Writing in 1932, at a time when Robertson had come to realize the evils of stabilization, Hawtrey declared: “The American experiment in stabilization from 1922 to 1928 showed that an early treatment could check a tendency either to inflation or to depression. . . . The American experiment was a great advance upon the practice of the nineteenth century,” when the trade cycle was accepted passively. When Governor Strong died, Hawtrey called the event “a disaster for the world.” Finally, Hawtrey was the main inspiration for the stabilization resolutions of the Genoa Conference of 1922.

—Murray N. Rothbard, America's Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2000), 176-177.

Government CANNOT Act in the General Interest When It Controls the Supply of Money

Yet even if we assumed that government could know what should be done about the supply of money in the general interest, it is highly unlikely that it would be able to act in that manner. As Professor Eckstein, in the article quoted above, concludes from his experience in advising governments:

Governments are not able to live by the rules even if they were to adopt the philosophy [of providing a stable framework].

Once governments are given the power to benefit particular groups or sections of the population, the mechanism of majority government forces them to use it to gain the support of a sufficient number of them to command a majority. The constant temptation to meet local or sectional dissatisfaction by manipulating the quantity of money so that more can be spent on services for those clamouring for assistance will often be irresistible. Such expenditure is not an appropriate remedy but necessarily upsets the proper functioning of the market. 

—F. A. Hayek, “The Denationalization of Money: An Analysis of the Theory and Practice of Concurrent Currencies,” in The Collected Works of F. A. Hayek, vol. 6, Good Money, Part II: The Standard, ed. Stephen Kresge (Indianapolis: Liberty Fund, 1999), 203.

Today, Money Is NOT an Effective Medium of Exchange, But a Tool of Government for Fleecing Us and for “Managing” the Economy

In fact, in endeavouring to design a better monetary order we at once encounter the difficulty of not really knowing what we want. What would be a really good money? To the present day, money is that part of the market order that government has not allowed to find its most effective form, and on which silly rulers and economists have doctored most. Yet it was not economists or statesmen who invented the market, though some have come to understand it a little; nor is it our present knowledge which can show us the best solutions, but the discoveries made by free experimentation. Those who chiefly needed money as an indispensable tool of trade, and who had first discovered it as a means for making most trade possible, were soon forced to use what money government gave them. And government jealously guarded its monopoly for quite different purposes than those for which money had been introduced. Today, money is not mainly an effective medium of exchange, but chiefly a tool of government for fleecing us and for ‘managing’ the economy. The result is that we are obliged to admit that we have little empirical evidence of how the various conceivable methods of supplying money would operate, and almost none about which kind of money the public would select if it had an opportunity to choose freely between several different and clearly distinguishable kinds of money. For this we must rely largely on our theoretical imagination, and try to apply to a special problem that understanding of the functioning of competition which we have gained elsewhere.

—F. A. Hayek, “The Future Unit of Value,” in The Collected Works of F. A. Hayek, vol. 6, Good Money, Part II: The Standard, ed. Stephen Kresge (Indianapolis: Liberty Fund, 1999), 240-241.

Gustav Cassel’s Fear of a Gold Shortage and His Stabilization Views Led to the Gold Exchange Standard and Cooperation Between Central Banks

The second important factor which determined the development of ideas on monetary policy was that the above-mentioned facts were partly contributory to the extraordinary influence exercised by two particular representatives of the mechanistic Quantity Theory of Money and the concept of a systematic stabilization of the price level, Irving Fisher and Gustav Cassel. The fluctuations in the value of money mentioned above necessarily aroused wide interest in Fisher’s proposal for stabilizing the value of gold, which he had been advocating for a long time; and the lively propaganda which was being circulated, particularly by the Stable Money Association which he had founded, had succeeded in making the concept of price stabilization as the objective of monetary policy into a virtually unassailable dogma. Cassel, who deserved the greatest credit for the stabilization of European currencies, contributed a further, extraordinarily effective argument in favour of the policy of stabilization, the influence of which upon actual developments it is impossible to overestimate. 

This was his prediction that gold production was not adequate for the annual increase of 3 per cent in the world stock of monetary gold which, on his calculations, would be required to maintain stability in the price level. 

Fear of the imminent shortage of gold, and the desire to arrive at a systematic policy for stabilizing the value of money, gave rise to two further ideas which dominated the period, and were expressed particularly in the resolutions of the conference on international economic relations in Genoa in 1922; a preference for the gold exchange standard as the object of stabilization in individual countries, and the recommendation of “Cooperation between Central Banks.” Both desires were to become extremely significant for the development of monetary policy over the next few years. Perhaps it is therefore appropriate at this point to also name the man who acquired special influence as the propagator of the ideas expressed by the Genoa Conference—even if he were not, as one might suspect, its instigator: R. G. Hawtrey of the British Treasury. 

—F. A. Hayek, “The Fate of the Gold Standard,” in The Collected Works of F. A. Hayek, vol. 5, Good Money, Part I: The New World, ed. Stephen Kresge (Indianapolis: Liberty Fund, 1999), 154.

To Combat the Depression by a Forced Credit Expansion Is to Attempt to Cure the Evil by the Very Means Which Brought It About

It seems certain, however, that we shall merely make matters worse if we aim at curing the deflationary symptoms and, at the same time (by the erection of trade barriers and other forms of state intervention), do our best to increase rather than to decrease the fundamental maladjustments. More than that: while the advantages of such a course are, to say the least, uncertain, the new dangers it creates are great. To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection—a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end. It would not be the first experiment of this kind that has been made. We should merely be repeating, on a much larger scale, the course followed by the Federal Reserve System in 1927, an experiment that Mr. A.C. Miller, the only economist on the Federal Reserve Board and at the same time its oldest member, has rightly characterized as “the greatest and boldest operation ever undertaken by the Federal Reserve System,” an operation that “resulted in one of the most costly errors committed by it or any other banking system in the last 75 years.” It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression. We must not forget that, for the last six or eight years, monetary policy all over the world has followed the advice of the stabilizers. It is high time that their influence, which has already done harm enough, should be overthrown.

—F. A. Hayek, “Monetary Theory and the Trade Cycle,” in Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, ed. Joseph T. Salerno (Auburn, AL: Ludwig von Mises Institute, 2008), 6-7.

It Was the Political Inability to Make That Choice That Led to the Debacle of the 1930s

The return of a universal gold standard would once again place money beyond the control of individual central banks. At that point, central bankers would once again have to choose between domestic monetary policy and the stability of the foreign exchange rate. It was the political inability to make that choice that led to the debacle of the 1930s. In his article “The Fate of the Gold Standard”, which appears as chapter 3, this volume, Hayek accused Keynes of the primary responsibility for the belief that the choice could be evaded. However, it was not only Keynes, but the whole of the economic literature devoted to the concept of the trade cycle that encouraged the belief that somehow or other the cycle could be minimized through monetary policy.

—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), 14.

It Was Keynes’s Use of Aggregates that Hayek Came to View as Being Keynes’s MOST DANGEROUS Contribution

 Both “The Economics of the 1930s as Seen from London” and “Personal Recollections of Keynes and the Keynesian Revolution” were written in the 1960s. In them, Hayek recounted that after the release of The General Theory he had a feeling, vague but enduring, that in order to do a full critique of Keynes he would need to do more than to criticize his model. Hayek disagreed with Keynes on both theory and policy. But it was Keynes’s methodological approach, specifically his use of aggregates, that Hayek came to view in retrospect as being his opponent’s most dangerous contribution. 

Now, it is easy to understand that Hayek might put things in this way in essays written in the 1960s. Macroeconomic modelling was then at its zenith, as was hubris about the economics profession’s ability to control the business cycle by applying fiscal ‘fine-tuning’. What doesn’t ring quite true in Hayek’s claim is that he was only vaguely becoming aware of this difference over methodology in the 1930s. As we saw in our discussion of Hayek’s earlier work on the United States economy, opposition to the use of statistical aggregates has long been a methodological principle among Austrians. Aggregates mask the movement of relative prices, and relative price movements are the central foci of Austrian theory.

—Bruce Caldwell, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 9, Contra Keynes and Cambridge: Essays, Correspondence, by F. A. Hayek (Indianapolis: Liberty Fund, 1995), 42-43.

Hayek Secured the Capital-Theoretic Foundation of Austrian Theory By Replacing “Average Period of Production” with the “Structure of Production”

 By the time that Hayek published his next major theoretical work, The Pure Theory of Capital, the world was at war. Few in the profession even noticed the book. Furthermore, it was clear to Hayek that even after a prodigious effort he had not gotten very far. True enough, he had been able to clear away Böhm-Bawerk’s “average period of production” and replace it with the far more complex notion of a structure of production, thereby securing the capital-theoretic foundation of Austrian theory. But he had made no further progress towards building on this new foundation a fully dynamic theory of the cycle. Hayek never returned to this task, hoping that it would be completed by others. It remains unfinished.

—Bruce Caldwell, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 9, Contra Keynes and Cambridge: Essays, Correspondence, by F. A. Hayek (Indianapolis: Liberty Fund, 1995), 42.

Monetary Theories of the Trade Cycle Are Generally Regarded as “Exogenous” (Instead of “Endogenous”) Theories

If we are to understand the present status of monetary theories of the trade cycle, we must pay special attention to the assumptions upon which they are based. At the present day, monetary theories are generally regarded as falling within the class of so-called “exogenous” theories, i.e., theories that look for the cause of the cycle not in the interconnections of economic phenomena themselves but in external interferences. Now it is, no doubt, often a waste of time to discuss the merits of classifying a theory in a given category. But the question of classification becomes important when the inclusion of a theory in one class or another implies, at the same time, a judgment as to the sphere of validity of the theory in question. This is undoubtedly the case with the distinction, very general today, between endogenous and exogenous theories—a distinction introduced into economic literature some twenty years ago by Bouniatian. Endogenous theories, in the course of their proof, avoid making use of assumptions that cannot either be decided by purely economic considerations, or regarded as general characteristics of our economic system—and hence capable of general proof. Exogenous theories, on the other hand, are based on concrete assertions whose correctness has to be proved separately in each individual case. As compared with an endogenous theory, which, if logically sound, can in a sense lay claim to general validity, an exogenous theory is at some disadvantage, inasmuch as it has, in each case, to justify the assumptions on which its conclusions are based.

Now as far as most contemporary monetary theories of the cycle are concerned, their opponents are undoubtedly right in classifying them, as does Professor Lowe in his discussion of the theories of Professors Mises and Hahn, among the exogenous theories; for they begin with arbitrary interferences on the part of the banks. This is, perhaps, one of the main reasons for the prevailing skepticism concerning the value of such theories. A theory that has to call upon the deus ex machina of a false step by bankers, in order to reach its conclusions is, perhaps, inevitably suspect. Yet Professor Mises himself—who is certainly to be regarded as the most respected and consistent exponent of the monetary theory of the trade cycle in Germany—has, in his latest work, afforded ample justification for this view of his theory by attributing the periodic recurrence of the trade cycle to the general tendency of central banks to depress the money rate of interest below the natural rate.

—F. A. Hayek, “The Fundamental Cause of Cyclical Fluctuations,” in Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, ed. Joseph T. Salerno (Auburn, AL: Ludwig von Mises Institute, 2008), 75-76. 

The Pressure for More and Cheaper Money Is a Political Force Which Monetary Authorities Have NEVER Been Able to Resist

The pressure for more and cheaper money is an ever-present political force which monetary authorities have never been able to resist, unless they were in a position credibly to point to an absolute obstacle which made it impossible for them to meet such demands. And it will become even more irresistible when these interests can appeal to an increasingly unrecognizable image of St. Maynard. There will be no more urgent need than to erect new defences against the onslaughts of popular forms of Keynesianism, that is, to replace or restore those restraints which, under the influence of his theory, have been systematically dismantled. It was the main function of the gold standard, of balanced budgets, and of the limitation of the supply of ‘international liquidity’, to make it impossible for the monetary authorities to capitulate to the pressure for more money. And it was exactly for that reason that all these safeguards against inflation, which had made it possible for representative governments to resist the demands of powerful pressure groups for more money, have been removed at the instigation of economists who imagined that, if governments were released from the shackles of mechanical rules, they would be able to act wisely for the general benefit. 

—F. A. Hayek, “Choice in Currency,” in The Collected Works of F. A. Hayek, vol. 6, Good Money, Part II: The Standard, ed. Stephen Kresge (Indianapolis: Liberty Fund, 1999), 119-120.

Should We Rely on the Price Mechanism to Provide Us with an Indicator of the Relative Scarcity of the Various Factors of Production?

In discussions of war economics it is generally taken for granted that the monetary authorities should always employ all the means at their disposal to keep rates of interest as low as possible. That it is possible to postpone a threatened rise of interest rates for a long time cannot be doubted. The real problem is whether it is desirable to do so. For nearly two hundred years economists fought fairly consistently against the popular argument in favour of such a policy; and until two or three years ago, when these old arguments experienced a sudden recrudescence, it was commonly regarded as highly dangerous. For the time being the prompt rise of the Bank Rate at the outbreak of war has provided a temporary answer. But with the infinitely greater demands for capital during actual warfare the problem is bound to return in much more acute and pressing form. 

Basically, the question at issue is the same as that discussed in the article on pricing versus rationing in the last issue of The Banker. Should we rely on the price mechanism to provide us with an indicator of the relative scarcity of the various factors of production? Or should we deliberately make this price mechanism inoperative and try to substitute for it a detailed regulation of all productive activity by a central authority? And the argument that the rate of interest should be allowed to express the real scarcity of capital is fundamentally the same as that with respect to any other price. But this similarity was never easy to see, since in the case of capital we have not to deal with a single concrete resource but with a somewhat abstract concept. And the more recent discussions, confining themselves entirely to the monetary influences at work, hardly have increased the understanding of this problem.

—F. A. Hayek, “The Economy of Capital,” in The Collected Works of F. A. Hayek, vol. 10, Socialism and War: Essays, Documents, Reviews, ed. Bruce Caldwell (Indianapolis: Liberty Fund, 1997), 157.

Every Explanation of Economic Crises MUST Include the Assumption that Entrepreneurs Have Committed Errors

Every explanation of economic crises must include the assumption that entrepreneurs have committed errors. But the mere fact that entrepreneurs do make errors can hardly be regarded as a sufficient explanation of crises. Erroneous dispositions which lead to losses all round will appear probable only if we can show why entrepreneurs should all simultaneously make mistakes in the same direction. The explanation that this is just due to a kind of psychological infection or that for any other reason most entrepreneurs should commit the same avoidable errors of judgment does not carry much conviction. It seems, however, more likely that they may all be equally misled by following guides or symptoms which as a rule prove reliable. Or, speaking more concretely, it may be that the prices existing when they made their decisions and on which they had to base their views about the future have created expectations which must necessarily be disappointed. In this case we might have to distinguish between what we may call justified errors, caused by the price system, and sheer errors about the course of external events. Although I have no time to discuss this further, I may mention that there is probably a close connection between this distinction and the traditional distinction between ‘endogenous’ and ‘exogenous’ theories of the trade cycle.

—F. A. Hayek, “Price Expectations, Monetary Disturbances, and Malinvestments,” in The Collected Works of F. A. Hayek, vol. 5, Good Money, Part I: The New World, ed. Stephen Kresge (Indianapolis: Liberty Fund, 1999), 235-236.

An Elaboration of the Theory of Capital Is a Prerequisite for a Thorough Disposal of Keynes’s Argument

I ought to explain why I failed to return to the charge after I had devoted much time to a careful analysis of his writings—a failure for which I have reproached myself ever since. It was not merely (as I have occasionally claimed) the inevitable disappointment of a young man when told by the famous author that his objections did not matter since Keynes no longer believed in his own arguments. Nor was it really that I became aware that an effective refutation of Keynes’s conclusions would have to deal with the whole macroeconomic approach. It was rather that his disregard of what seemed to me the crucial problems made me recognize that a proper critique would have to deal more with what Keynes had not gone into than with what he had discussed, and that in consequence an elaboration of the still inadequately developed theory of capital was a prerequisite for a thorough disposal of Keynes’s argument. 

So I started on this task intending it to lead to a discussion of the determinants of investment in a monetary system. But the preliminary ‘pure’ part of this work proved to be much more difficult, and took me very much longer, than I had expected. When war broke out, making it doubtful that publication of such a voluminous work would be possible, I put out as a separate book what had been meant as a first step of an analysis of the Keynesian weaknesses, which itself was indefinitely postponed.⁷

__________

⁷F. A. Hayek, The Pure Theory of Capital

—F. A. Hayek, “The Keynes Centenary: The Austrian Critique,” in The Collected Works of F. A. Hayek, vol. 9, Contra Keynes and Cambridge: Essays, Correspondence, ed. Bruce Caldwell (Indianapolis: Liberty Fund, 1995), 251-252.