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).

BIBLIOGRAPHY

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.

Hayek on the Flaws and Irrelevance of his Trade Cycle Theory

There is a series of interviews conducted with Hayek late in his life, and published in 1983 as Nobel Prize-Winning Economist: Friedrich A. von Hayek (Regents of the University of California, 1983). That work makes rewarding reading. In one of the interviews, Hayek was asked about the legacy of his Austrian business cycle theory (ABCT):

HIGH: Have the economic events since you wrote on trade cycle theory tended to strengthen or weaken your ideas on the Austrian theory of the trade cycle?

HAYEK: On the whole, strengthen, although I see more clearly that there’s a very general schema which has to be filled in in detail. The particular form I gave it was connected with the mechanism of the gold standard, which allowed a credit expansion up to a point and then made a certain reversal possible. I always knew that in principle there was no definite time limit for the period for which you could stimulate expansion by rapidly accelerating inflation. But I just took it for granted that there was a built-in stop in the form of the gold standard, and in that I was a little mistaken in my diagnosis of the postwar development. I knew the boom would break down, but I didn’t give it as long as it actually lasted. That you could maintain an inflationary boom for something like twenty years I did not anticipate.

While on the one hand, immediately after the war I never believed, as most of my friends did, in an impending depression, because I anticipated an inflationary boom. My expectation would be that the inflationary boom would last five or six years, as the historical ones had done, forgetting that then the termination was due to the gold standard. If you had no gold standard—if you could continue inflating for much longer—it was very difficult to predict how long it would last. Of course, it has lasted very much longer than I expected. The end result was the same.

HIGH: The Austrian theory of the cycle depends very heavily on business expectations being wrong. Now, what basis do you feel an economist has for asserting that expectations regarding the future will generally be wrong?

HAYEK: Well, I think the general fact that booms have always appeared with a great increase of investment, a large part of which proved to be erroneous, mistaken. That, of course, fits in with the idea that a supply of capital was made apparent which wasn’t actually existing. The whole combination of a stimulus to invest on a large scale followed by a period of acute scarcity of capital fits into this idea that there has been a misdirection due to monetary influences, and that general schema, I still believe, is correct.

But this is capable of a great many modifications, particularly in connection with where the additional money goes. You see, that’s another point where I thought too much in what was true under prewar conditions, when all credit expansion, or nearly all, went into private investment, into a combination of industrial capital. Since then, so much of the credit expansion has gone to where government directed it that the misdirection may no longer be overinvestment in industrial capital, but may take any number of forms. You must really study it separately for each particular phase and situation. The typical trade cycle no longer exists, I believe. But you get very similar phenomena with all kinds of modifications.
(Nobel Prize-Winning Economist: Friedrich A. von Hayek, pp. 183–186).

One cannot help but notice the illogic running through Hayek’s responses. First, Hayek is completely and embarrassingly wrong on two points:

(1) The golden age of capitalism (1945-1973) was not characterised by “rapidly accelerating inflation”: inflation was low, subdued and there was no tendency whatsoever towards its acceleration for virtually all the period. It was only in 1968 that inflation in many countries started to accelerate.

(2) The stagflation crisis of the 1970s was not caused by an Austrian business cycle: it was the result of (1) wage–price spirals, (2) the speculative activity caused by the break up of Bretton Woods in 1971, (3) negative supply shocks in the prices of commodities which could have been prevented had the US not dismantled its commodity buffer stock polices in the 1960s, and (4) the oil shocks (see “Stagflation in the 1970s: A Post Keynesian Analysis,” June 24, 2011).

Now, on the one hand, Hayek makes some surprising admissions:

(1) His original trade cycle theory assumed the existence of a gold standard, and that this would cause an automatic mechanism causing the end of a credit expansion.

(2) Hayek thought that the postwar boom would last only “five or six years,” and he was completely wrong.

(3) Hayek’s original theory assumed that capital would be directed to industrial expansion, but credit flows after 1945 were, and remain, rather different in nature, with credit flowing to important other sources as well. This can only mean that Hayek’s trade cycle effects would be less and less relevant, as he himself admits.

(4) Hayek recognises his theory had become far less relevant: “You must really study it separately for each particular phase and situation. The typical trade cycle no longer exists [my emphasis], I believe. But you get very similar phenomena with all kinds of modifications.”

The qualification that each historical cycle must be examined to see if it can in fact be explained by ABCT, since there is the possibility that it might not be, was also stressed by Israel M. Kirzner (see “Kirzner on Austrian Business Cycle Theory,” May 30, 2011). Yet when modern Austrians are pressed to identify real world cycles that are not explained by ABCT, most of them are reduced to dumbfounded silence.

Having admitted that his “typical” trade cycle no longer existed, Hayek never admitted what he should have, had he been more honest: that his trade cycle theory had serious flaws and, even if it had been relevant before 1931, it had become largely irrelevant.

Bruce Caldwell puts his finger on exactly this point:

“If one takes seriously ... [sc. Hayek’s] later work on the theory of complex phenomena, then one cannot make precise predictions about the path that a cycle must take, which is what his original cycle theory purported to do. In my opinion, Hayek began to recognize the difficulties with his approach as he responded to critics while laboring over The Pure Theory of Capital ... As noted earlier, he gave hints about those limitations in his 1978 oral-history reminiscences ... and again (and more provocatively) a few years later in his fiftieth-anniversary address .. at the London School of Economics (LSE). His ultimate position seems to have been very close to that of T. W. Hutchison ... , who expressed doubts about whether a general theory of the cycle was possible at all.” (Caldwell 2004: 326).

By recognising that his trade cycle theory was not a general theory of cycles, Hayek in fact eventually had the same view as Ludwig Lachmann, Joseph Schumpeter and Israel M. Kirzner: ABCT cannot be used to explain all business cycles (Batemarco 1998: 222).

And there is a further issue here. Hayek’s original trade cycle theory used static equilibrium theory, and also assumes that all markets do in fact clear (Caldwell 2004: 324), partly by glossing over the role of uncertainty and assuming perfect foresight. But severe problems with Hayek’s static equilibrium theory had already emerged in the 1930s:

“by the middle of the 1930s, problems with [Hayek’s] static equilibrium theory had become ever more evident, as questions of the role of expectations came to the fore and, and, with them, the recognition that earlier models had assumed perfect foresight” (Caldwell 2004: 224).

“Hayek’s changing assessment of the importance of equilibrium theory has some consequences for our story. The most telling of these concerns Hayek’s trade cycle theory, a paradigmatic example of equilibrium theory, one that Witt (1997, 48) describes as ‘an impressive example of allied price theoretical reasoning that may even delight a Chicago equilibrium economist.’ But, as Witt goes on to observe, if one rejects the usefulness of equilibrium analysis, then Hayek’s step-by-set story of how the cycle unfolds, one in which ‘each single stage necessarily had to be followed by the next one’ (46), can no longer be maintained. Witt concludes that Hayek’s cycle theory may well be incompatible with his later theory of spontaneous orders, a concern that others have voiced” (Caldwell 2004: 228).

In light of all this, one can also only agree with Bruce Caldwell that Hayek’s trade cycle theory is now “chiefly of antiquarian interest” (Caldwell 2004: 325).

To conclude, I link to a video below where Bruce Caldwell, Philip Mirowsky and Robert Skidelsky discuss Keynes versus Hayek on the Great Depression, as well as issues related to Hayek’s trade cycle theory (in the first half of the discussion).

Caldwell makes another valid point: Hayek needed a dynamic theory of a capital-using monetary economy, and he did not have the mathematic skills to do this. Around 1936/37, Hayek’s engagement with the socialist calculation debate caused him to pay more attention to the knowledge problem, and how this was also relevant to his business cycle theory.

At the end of the video there is some discussion about the scope for constructive dialogue between Austrians and Post Keynesians (from 13.19 minutes).




BIBLIOGRAPHY

Batemarco, R. J. 1998. “Austrian Business Cycle Theory,” in P. J. Boettke (ed.), The Elgar Companion to Austrian Economics, Elgar, Cheltenham, UK. 216–336.

Caldwell, B. 2004. Hayek’s Challenge: An Intellectual Biography of F.A. Hayek, University of Chicago Press, Chicago and London.

Nobel Prize-Winning Economist: Friedrich A. von Hayek. Interviewed by Earlene Graver, Axel Leijonhufvud, Leo Rosten, Jack High, James Buchanan, Robert Bork, Thomas Hazlett, Armen A. Alchian, Robert Chitester, Regents of the University of California, 1983.

Witt, U. 1997. “The Hayekian Puzzle: Spontaneous Order and the Business Cycle,” Scottish Journal of Political Economy 44: 44–58.

Vaughn on Mises’s Trade Cycle Theory

Karen I. Vaughn’s book Austrian Economics in America: The Migration of a Tradition (Cambridge and New York, 1994) is invaluable, and a passage I have recently read is worth quoting:

“Mises never discusses the possibility of systematic speculative error except in the context of his trade cycle theory, in which speculators-investors are misled by improper monetary signals emanating from a fractional reserve banking. Yet if the future cannot be predicted, or as Shackle would say, if the future is created out of the actions of the past, why is it not least conceivably possible for speculative activity to be on net incorrect at least some of the time? Certainly, we have the empirical evidence of speculative bubbles that are endogenous to markets as an example of market instability. One would think that the extent and potential limiting factors that affect such endogenous instabilities would be of great importance for fully understanding market orders, yet it is an issue surprisingly missing in the Austrian literature. Hence, although, we can appreciate the force of Mises’ argument as far as it goes, it seems that a crucial part of the case for the effective functioning of a market economy is missing.” (Vaughn. 1994: 87–88).

Vaughn is entirely correct: the Austrians’ trade cycle theory is flawed by failing to take into account Keynesian uncertainty, subjective expectations and a severe failure to deal with the instabilities caused by asset bubbles and debt deflation.

BIBLIOGRAPHY

Vaughn, K. I. 1994. Austrian Economics in America: The Migration of a Tradition, Cambridge University Press, Cambridge and New York.

There was no US Recovery in 1921 under Austrian Trade Cycle Theory!

Austrian economists and their sympathizers are fond of pointing to the US recession of 1920–1921 as proof that recessions can end “quickly” with a recovery and no government intervention.

In fact, their claims are false and misleading, as I have shown here:

“The US Recession of 1920–1921: Some Austrian Myths,” October 23, 2010.

The following points should be made in response to them:

(1) The recession lasted from January 1920 to July 1921, or for a period of 18 months. This was a long recession by the standards of the post-1945 US business cycle, where the average duration of US recessions was just 11 months. The average duration of recessions in peacetime from 1854 to 1919 was 22 months, and the average duration of recessions from 1919 to 1945 was 18 months (Knoop 2010: 13). Therefore the recession of 1920–1921 was not even short by contemporary standards: it was of average length.

(2) The period of 1920–1921 was not a depression (a downturn where real GDP contracted by 10% or more): it was mild to moderate recession, with positive supply shocks. Christina Romer argues that actual decline in real GNP was only about 1% between 1919 and 1920 and 2% between 1920 and 1921 (Romer 1988: 109). So in fact real output moved very little, and the “growth path of output was hardly impeded by the recession” (Romer 1988: 108–112). The positive supply shocks that resulted from the resumption in international trade after WWI actually benefited certain sectors of the economy (Romer 1988: 111).

(3) there was no large collapsing asset bubble in 1920/1921, of the type that burst in 1929, which was funded by excessive private-sector debt;

(4) Because of (3) the economy was not gripped by the death agony of severe debt deflation in 1920-1921;

(5) There was no financial and banking crisis, as in 1929–1933;

(6) The US economy in fact had significant government intervention in 1921: it had a central bank changing interest rates. The Fed lowered rates and had a role in ending this recession: in April and May 1921, Federal Reserve member banks dropped their rates to 6.5% or 6%. In November 1921, there were further falls in discount rates: rates fell to 4.5% in the Boston, Philadelphia, New York, and to 5% or 5.5% in other reserve banks (D’Arista 1994: 62). By June 1922, the discount rate was lowered again to 4%, and the recovery gained momentum.

It is the height of stupidity to claim that a recession that was ended partly by Federal Reserve intervention through interest rate lowering can be ascribed to the “free market,” or is a vindication of Austrian economics. Nor did the recession end “quickly,” either by contemporary or modern (post-1945) standards.

And there is yet another absurd contradiction here.

An Austrian cannot claim that the recession of 1920–1921 ended with a real and proper recovery. Why? The Fed lowered interest rates. Why did this not cause an Austrian trade cycle and unsustainable boom, distorting capital structure? If it did not, they must explain why the Fed’s lowering of interest rates did not make the market rate fall below the natural rate. How did the economy avoid distortions to its capital structure when it had a fractional reserve banking system and Fed inflating the money supply in 1921/22? How could there have been any real “recovery” in 1921?

In other words, by the Austrians’ own economic theory, the “recovery” of 1921 was no recovery at all: just the beginning of another Austrian business cycle!

BIBLIOGRAPHY

D’Arista, J. W. 1994. The Evolution of U.S. Finance, Volume 1: Federal Reserve Monetary Policy: 1915–1935, M. E. Sharpe, Armonk, New York.

Knoop, T. A. 2010. Recessions and Depressions: Understanding Business Cycles (2nd edn), Praeger, Santa Barbara, Calif.

Romer, C. 1988. “World War I and the Postwar Depression: A Reinterpretation based on alternative estimates of GNP,” Journal of Monetary Economics 22.1: 91–115.