Friday, July 1, 2011

ABCT and Full Employment

In Money, Bank Credit and Economic Cycles (Auburn, Ala., 2006), Jesus Huerta de Soto attempts to defend the Austrian business cycle theory (ABCT) against the charge that it fails to consider what happens when idle resources are available:
“Critics of the Austrian theory of the business cycle often argue that the theory is based on the assumption of the full employment of resources, and that therefore the existence of idle resources means credit expansion would not necessarily give rise to their widespread malinvestment. However this criticism is completely unfounded. As Ludwig M. Lachmann has insightfully revealed, the Austrian theory of the business cycle does not start from the assumption of full employment. On the contrary, almost from the time Mises began formulating the theory of the cycle, in 1929, he started from the premise that at any time a very significant volume of resources could be idle. In fact Mises demonstrated from the beginning that the unemployment of resources was not only compatible with the theory he had developed, but was actually one of its essential elements.” (Huerta de Soto 2006: 265–508).
But Huerta de Soto has done nothing here but engage in a sleight of hand: the charge against ABCT is that its cycle effects do not occur if the factor inputs and consumer goods required by expanded demand are not scarce. That an economy might not be at full employment and may have idle resources when the money supply is expanded does answer the question of how the cycle effects happen, if the relevant factor inputs continue to remain abundant, either through domestic production through increasing capacity utilization, idle stocks or even by international trade.

Moreover, the claim that “unemployment of resources was not only compatible with … [the trade cycle theory Mises] had developed, but was actually one of its essential elements” is not supported by a reading of Mises. All that Mises does is admit the fact that capitalist economies do have idle resources, but then says that his cycle effects require that this abundance declines and the relevant factor inputs become scarce. In “Monetary Stabilization and Cyclical Policy” (1928) Mises has the following to say:
“Since it always requires some time for the market to reach full ‘equilibrium,’ the ‘static’ or ‘natural’ prices, wage rates and interest rates never actually appear. The process leading to their establishment is never completed before changes occur which once again indicate a new ‘equilibrium.’ At times, even on the unhampered market, there are some unemployed workers, unsold consumers’ goods and quantities of unused factors of production, which would not exist under ‘static equilibrium.’ With the revival of business and productive activity, these reserves are in demand right away. However, once they are gone, the increase in the supply of fiduciary media necessarily leads to disturbances of a special kind. In a given economic situation, the opportunities for production, which may actually be carried out, are limited by the supply of capital goods available. Roundabout methods of production can be adopted only so far as the means for subsistence exist to maintain the workers during the entire period of the expanded process. All those projects, for the completion of which means are not available, must be left uncompleted, even though they may appear technically feasible—that is, if one disregards the supply of capital. However, such businesses, because of the lower loan rate offered by the banks, appear for the moment to be profitable and are, therefore, initiated. However, the existing resources are insufficient. Sooner or later this must become evident. Then it will become apparent that production has gone astray, that plans were drawn up in excess of the economic means available, that speculation, i.e., activity aimed at the provision of future goods, was misdirected.” (Mises 2006 [1978]: 110).
With respect to Hayek’s presentation of the Austrian trade cycle theory in Prices and Production, the evidence does not support Huerta de Soto either. Hayek explicitly conceded that he had assumed full employment in Prices and Production (1931):
“As it is sometimes alleged that the ‘Austrians’ were unaware of the fact that the effect of an expansion of credit will be different according as there are unemployed resources available or not, the following passage from Professor Mises’ Geldwertstabilisierung und Konjunkturpolitik (1928, p. 49) perhaps deserves to be quoted: ‘Even on an unimpeded market there will be at times certain quantities of unsold commodities which exceed the stocks that would be held under static conditions, of unused productive plant, and of unused workmen. The increased activity will at first bring about a mobilisation of these reserves. Once they have been absorbed the increase of the means of circulation must, however, cause disturbances of a peculiar kind.’ In Prices and Production, where I started explicitly from an assumed equilibrium position, I had, of course, no occasion to deal with these problems. (Hayek 1975 [1939]: 42, n. 1).
There is no way to deny this fact. The starting point in Prices and Production was in fact the assumption of an economy in full employment equilibrium.

In Monetary Theory and the Trade Cycle (1929) [English trans. 1933 by N. Kaldor and H.M. Croome]), Hayek had also made it perfectly clear full employment equilibrium was his starting point:
“The purpose of the foregoing chapter was to show that only the assumption of primary monetary changes can fulfill the fundamentally necessary condition of any theoretical explanation of cyclical fluctuations—a condition not fulfilled by any theory based exclusively on “real” processes. If this is true then at the outset of theoretical exposition, those monetary processes must be recognized as decisive causes. For we can gain a theoretically unexceptionable explanation of complex phenomena only by first assuming the full activity of the elementary economic interconnections as shown by the equilibrium theory, and then introducing, consciously and successively, just those elements that are capable of relaxing these rigid interrelationships.” (Hayek 2008: 47).
The assumption of “full activity of the elementary economic interconnections as shown by the equilibrium theory” is nothing but a static equilibrium assumption of full employment.

In a letter written to John Hicks in 1967, Hayek confirms that his theory required the assumption of full employment at the beginning of the process:
Hicks to Hayek, November 27, 1967
We have (a) full employment, (b) static expectations, (c) ‘equilibrium’ at every stage, so that demand = supply in every market, prices being determined by current demand and supply. Add to these the Wicksell assumption, of a pure credit economy and we clearly find that if there were in lags, the market rate of interest cannot be reduced below the natural rate in an equilibrium position; ...

Friedrich August Hayek, Good money, Volume 6, p. 100.

Hayek to Hicks, December 2, 1967
... I accept assumption (a), full employment .... (Hayek 1999: 102).

Hayek, F. A. von. 1939. Profits, Interest and Investment, Routledge and Kegan Paul, London

Hayek, F. A. von. 1975 [1939]. Profits, Interest and Investment, Augustus M. Kelley Publishers, Clifton, NJ.

Hayek, F. A. von, 2008. Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, Ludwig von Mises Institute, Auburn, Ala.

Hayek, F. A. von, 1999. Collected Works of F.A. Hayek, Volume 6: Good Money, Part II: The Standard, Routledge, London.

Huerta de Soto, J. 2006. Money, Bank Credit and Economic Cycles (trans. M. A. Stroup), Ludwig von 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.


  1. Very very good posts in the past few days.

    There is no theory of business cycles that is universally true. We can not just make a general assumption and apply it rigidly to very unique economic crises that differ from one another.

    The Austrian Business Cycle Theory, which is not necessarilly Austrian at all, relates to a very particular and specific situation that is not easily applied to the real world. It involves assumptions about a particular state of things, in order to observe a phenomenon in isolation. However, nothing in this world exists in isolation.

  2. Probably I should write something about what was right about ABCT: for example, the idea of analyzing cycles through a monetary theory, or trying to work out the role of money in influencing real output, was a step forward over Classical and earlier neoclassical theories, certainly better than the view that Say's law operates and aggregate demand will equal aggregate supply.

  3. And also the fact that when factor inputs are scare you do get inflationary effects, but not necessarily the capital distortions proposed by the theory.

    Frankly, one of the secrets of capitalism was its fractional reserve banking (FRB) system, able to expand the money supply endogenously in accordance with demand for credit, and use idle resources.

    FRB increased commerce, trade and investment very significantly in the 19th century. The intelligent defenders of capitalism would be celebrating FRB, not condemning it.

  4. You know you have lost the argument when you start blocking the other person's non-offensive comments. I have totally gutted your funny theory of how idle resources destroys ABCT. That you still persist with this only shows you as a propagandist.

  5. Your last comment was in fact nothing but abuse, so don't waste my time posting here unless you want to offer counterarguments. I'll publish this latest comment, however.

  6. Again: if you want to dispute what is written above, try:

    (1) disproving that full employment equilibrium is the starting point for Hayek's trade cycle theory in Prices and Production; or

    (2) refuting Huerto de Soto's plain admission that idle resources can, and do, exist in modern capitalist systems (Huerta de Soto 2006: 265–508).

    Your peculiar that they don't exist is at variance with what other Austrians - like de Soto, Lachmann, and the later Hayek - actually say.

  7. What if we applied the other aspects of Hayek's argument to an economy without full employment?