Mises’s “Evenly Rotating Economy” (ERE) and ABCT

Mises’s early work on the Austrian business cycle theory (ABCT) uses the Wicksellian natural interest rate concept and Wicksell’s monetary equilibrium analysis. This can be seen here:

“[Mises] surely made use of the natural and market rate concepts, developing Wicksell's analysis of the upward price spiral caused by a too low market rate into a theory of the business cycle” (Horwitz 2000: 77).

“Wicksell distinguishes between the natural rate of interest (natürliche Kapitalzins), or the rate of interest that would be determined by supply and demand if actual capital goods were lent without the mediation of money, and the money rate of interest (Geldzins), or the rate of interest that is demanded and paid for loans in money or money substitutes. The money rate of interest and the natural rate of interest need not necessarily coincide, since it is possible for the banks to extend the amount of their issues of fiduciary media as they wish and thus to exert a pressure on the money rate of interest that might bring it down to the minimum set by their costs. Nevertheless, it is certain that the money rate of interest must sooner or later come to the level of the natural rate of interest, and the problem is to say in what way this ultimate coincidence is brought about.
Up to this point Wicksell commands assent; but his further argument provokes contradiction. According to Wicksell, at every time and under all possible economic conditions there is a level of the average money rate of interest at which the general level of commodity prices no longer has any tendency to move either upwards or downwards. He calls it the normal rate of interest; its level is determined by the prevailing natural rate of interest, although, for certain reasons which do not concern our present problem, the two rates need not coincide exactly. When, he says, from any cause whatever, the average rate of interest is below this normal rate, by any amount, however small, and remains at this level, a progressive and eventually enormous rise of prices must occur ‘which would naturally cause the banks sooner or later to raise their rates of interest.’ Now, so far as the rise of prices is concerned, this may be provisionally conceded. But it still remains inconceivable why a general rise in commodity prices should induce the banks to raise their rates of interest ... ” (Mises 2009 [1953]: 355).

“In conformity with Wicksell’s terminology, we shall use ‘natural interest rate’ to describe that interest rate which would be established by supply and demand if real goods were loaned in natura [directly, as in barter] without the intermediary of money. ‘Money rate of interest’ will be used for that interest rate asked on loans made in money or money substitute.” (Mises 2006 [1978]: 107–108).

“The ‘natural interest rate’ is established at that height which tends toward equilibrium on the market. The tendency is toward a condition where no capital goods are idle, no opportunities for starting profitable enterprises remain unexploited and the only projects not undertaken are those which no longer yield a profit at the prevailing ‘natural interest rate’” (Mises 2006 [1978]: 109; from Monetary Stabilization and Cyclical Policy [1928]).

So as late as 1928 in Monetary Stabilization and Cyclical Policy (1928), Mises is still using the Wicksellian natural interest rate concept.

I have recently seen this attempt to defend Mises’ early versions of ABCT, by invoking his later concept of the “evenly rotating economy”/stationary economy concept:

“The point Mises is making in the [sc. quotes] ... is that the natural interest rate is the rate of interest that would arise in the [“evenly rotating economy”]... It is the value towards which interest rates in the real world economy tend though there are real world factors that take the interest rate away from the natural interest rate.”

But a reading of the earlier work of Mises in works cited above does not support this:

(1) There is not one reference to the concept of the “evenly rotating economy” (ERE) in The Theory of Money and Credit (trans. J. E. Batson; Mises Institute, Auburn, Ala. 2009 [1953]). On pages 349–366 where Mises sets out his trade cycle theory, he uses the Wicksellian natural interest rate concept and Wicksellian monetary equilibrium analysis.

(2) There is not one reference to the concept of the “evenly rotating economy” in Monetary Stabilization and Cyclical Policy (1928), and again Mises is still using the Wicksellian natural interest rate (p. 99ff.).

The “evenly rotating economy” just like the “originary interest rate” appears in Human Action, not in these earlier works. The concept of the “evenly rotating economy” needs clarification:

“In Human Action, Mises advanced the Austrian theory of money by delivering a shattering blow to the very concept of Walrasian general equilibrium. To arrive at that equilibrium, the basic data of the economy—values, technology, and resources—must all be frozen and understood by every participant in the market to be frozen indefinitely. Given such a magical freeze, the economy would sooner or later settle into an endless round of constant prices and production, with each firm earning a uniform rate of interest (or, in some constructions, a zero rate of interest). The idea of certainty and fixity in what Mises called “the evenly rotating economy” is absurd, but what Mises went on to show is that in such a world of fixity and certainty no one would hold cash balances. Everyone’s demand for cash balances would fall to zero. For since everyone would have perfect foresight and knowledge of his future sales and purchases, there would be no point in holding any cash balance at all.” (Rothbard 2011: 697).

“The Evenly Rotating Economy is a fictitious system in which there are no price changes whatever – i.e., there is perfect price stability. The concept is used to illustrate the function of entrepreneurship and to demonstrate meaning of profit and loss by hypothesizing a system where they are absent.”
http://wiki.mises.org/wiki/Evenly_Rotating_Economy

“… this line of argument makes it necessary to clarify the precise meaning of general equilibrium, as well as its role in economic analysis. Mises argued that general equilibrium—which he called the stationary economy (stationäre Wirtschaft)—is a purely methodological device. It is an imaginary construct (Gedankenbild) that has no counterpart in the real world. Its only purpose is for the definition of profit and loss.” (Hülsmann 2007: 773).

If Mises really believed that “the natural interest rate is the rate of interest that would arise in the ERE. It is the value towards which interest rates in the real world economy tend though there are real world factors that take the interest rate away from the natural interest rate,” then ABCT has no application to real world capitalism. Why?

In the real world, economies are growing, and there can never be an “endless round of constant prices and production.” This would require an economy without growth, frozen in time, for a single natural rate of interest to even exist. As Sraffa showed, even in a barter economy with growth, there can be as many natural rates of interest as there are commodities.

Yet ABCT requires a single natural rate of interest in the real world for the market/bank rate to coincide with, in order that we can avoid the cycle effects allegedly caused by ABCT.

BIBLIOGRAPHY

Horwitz, S. 2000. Microfoundations and Macroeconomics: An Austrian Perspective, Routledge, London and New York.

Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism, Ludwig von Mises Institute, Auburn, Ala.

Mises, L. 1998. Human Action: A Treatise on Economics, Mises Institute, Auburn, Ala.

Mises, L. von. 2006 [1978]. The Causes of the Economic Crisis and Other Essays Before and After the Great Depression, Ludwig von Mises Institute, Auburn, Ala.

Mises, L. von, 2009 [1953]. The Theory of Money and Credit (trans. J. E. Batson), Mises Institute, Auburn, Ala.

Rothbard, M. 2011. Economic Controversies, Ludwig von Mises Institute, Auburn, Ala. p. 697.