Wednesday, June 29, 2011

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).


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.


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

Tuesday, June 28, 2011

Informal Logical Fallacies and Cognitive Biases

Just like formal fallacies, both informal logical fallacies and cognitive biases are a threat to clear reasoning and argument. One can consult these for basic lists of informal fallacies and cognitive biases:
Bradley Dowden, “Fallacies,” Internet Encyclopedia of Philosophy.

“List of Fallacies,” Wikipedia.

“List of Cognitive Biases,” Wikipedia.
I. Informal Logical Fallacies
In brief, informal fallacies can be divided into:
(1) Fallacies of relevance;
(2) Fallacies of defective induction;
(3) Fallacies of presumption;
(4) Fallacies of ambiguity (sophism)
A detailed list of the fallacies can be seen here:
(1) Fallacies of Relevance
Irrelevant Appeals
Appeal to emotion (argument ad populum)
Appeal to pity (argument ad misericordiam)
Appeal to Force (argumentum ad baculum)
Appeal to Authority (argumentum ad verecundiam)
Appeal to nature (argument from nature)
Appeal to Ignorance (argumentum ad ignoratiam)
Red herring fallacy
Irrelevant Conclusion (ignoratio elenchi)
Straw man argument
Ad Hominem Argument
Poisoning the well
Guilt by association
Naturalistic fallacy
Moralistic Fallacy
Argument from silence (argumentum ex silentio)
Genetic fallacy
Gambler’s Fallacy
Tu quoque
(2) Fallacies of defective induction
Argument from Ignorance (ad ignorantiam)
Appeal to Inappropriate Authority (ad verecundiam)
False cause
Hasty generalization
Faulty generalization
Other inductive fallacies
Slothful induction
Overwhelming exception
Biased sample
Misleading vividness
Statistical special pleading
(3) Fallacies of presumption (fallacies of illegitimate presumption)
Complex question
False cause
Begging the question
Converse accident
No True Scotsman Fallacy (fallacy of ambiguity and presumption)
(4) Fallacies of ambiguity (sophisms)
Fallacy of equivocation
Fallacy of amphiboly
Fallacy of accent
Fallacy of composition
Fallacy of Division
Other fallacies relevant to economics include the following:
(1) Paradox of thrift/saving
(2) Paradox of costs
(3) Paradox of debt
(4) Paradox of liquidity
(5) Paradox of tranquillity (Minsky).
II. Cognitive Biases

In modern psychology, an important theory about how we make decisions under uncertainty is the “heuristic and biases” method of Tversky and Kahneman (1974; Kahneman et al. 1982). This posits that human being use heuristics, which are short cuts to solve problems that are not always reliable, and that we are subject to cognitive biases that might impair the success of our decisions. As I have said previously, the modern Post Keynesian theory of subjective expectations can use these theories and focus on how cognitive biases influence the investment decision and how investment fluctuates.

The classification of cognitive biases is below:
(1) Decision-making and Behavioural biases
Attentional Bias
Bandwagon effect
Bias blind spot
Choice-supportive bias
Confirmation bias
Congruence bias
Contrast effect
Denomination effect
Distinction bias
Endowment effect
Experimenter’s or Expectation bias
Focusing effect
Framing effect
Hostile media effect
Hyperbolic discounting
Illusion of control
Impact bias
Information bias
Irrational escalation
Loss aversion
Mere exposure effect
Money illusion
Moral credential effect
Negativity bias
Neglect of probability
Normalcy bias
Omission bias
Outcome bias
Planning fallacy
Post-purchase rationalization
Pseudocertainty effect
Restraint bias
Selective perception
Semmelweis reflex
Social comparison bias
Status quo bias
Unit bias
Wishful thinking
Zero-risk bias
(2) Biases in probability and belief
Ambiguity effect
Anchoring effect
Attentional bias
Availability heuristic
Availability cascade
Base rate neglect or Base rate fallacy
Belief bias
Clustering illusion
Conjunction fallacy
Forward Bias
Gambler’s fallacy
Hindsight bias
Illusory correlation
Observer-expectancy effect
Optimism bias
Ostrich effect
Overconfidence effect
Positive outcome bias
Pessimism bias
Primacy effect
Recency effect
Disregard of regression toward the mean
Subadditivity effect
Subjective validation
Well travelled road effect
(3) Social biases
Actor–observer bias
Dunning–Kruger effect
Egocentric bias
Forer effect (aka Barnum effect)
False consensus effect
Fundamental attribution error
Halo effect
Illusion of asymmetric insight
Illusion of transparency
Illusory superiority
Ingroup bias
Just-world phenomenon
Moral luck
Outgroup homogeneity bias
Projection bias
Self-serving bias
System justification
Trait ascription bias
Ultimate attribution error
(4) Memory errors
Egocentric bias
False memory
Hindsight bias
Reminiscence bump
Rosy retrospection
Self-serving bias
Telescoping effect
Von Restorff effect
III. Cognitive Closure?
There are some philosophers like Colin McGinn and even Noam Chomsky who claim that human beings are subject to a phenomenon called cognitive closure, the belief that certain problems are insolvable, and that our minds are “closed”: that our minds are subject to cognitive limitations such that we cannot begin to understand certain ideas and concepts, or solve some problems. The mind-body problem, identity, and free will might be such problems:
“We … [sc. suffer] from what I call ‘cognitive closure’ with respect to the mind-body problem. Just as a dog cannot be expected to solve the problems about space and time and the speed of light that it took a brain like Einstein's to solve, so maybe the human species cannot be expected to understand how the universe contains mind and matter in combination.” (McGinn 2002: 182).
I wonder whether the problem of induction might be added to the list? (although many philosophers might argue that it has in fact been solved: there is no rational justification for it).

However, other philosophers disagree with the “cognitive closure” thesis. Daniel Dennett presents a good case against it in Darwin’s Dangerous Idea: Evolution and the Meanings of Life (London, 1996) pp. 381–383. In essence, Dennett thinks that language makes the difference: as is well known, there are in principle an infinite number of meaningful sentences that could be constructed in any natural language. There is, he thinks, a set of possible sentences that best describe the solution to the mind–body problem, and why could we not understand that set of propositions? If the problem is solvable, then it could be explained in natural language. Although Dennett does not rule out the possibility of ‘cognitive closure,’ he concludes that there is “no evidence of the reality or even likelihood of ‘cognitive closure’ in human beings” (Dennett 1996: 382). That appears to be good news for the power of the human mind and human reason!


Copi, I. M., Cohen, C. and K. McMahon. 2011. Introduction to Logic (14th edn), Pearson Education, Upper Saddle River, N.J. and Harlow.

Dennett, D. C. 1996. Darwin’s Dangerous Idea: Evolution and the Meanings of Life, Penguin, London.

Kahneman, D., Slovic, P. and A. Tversky (eds), 1982. Judgment Under Uncertainty: Heuristics and Biases, Cambridge University Press, Cambridge.

McGinn, C. 2002. The Making of a Philosopher: My Journey Through Twentieth-Century Philosophy, HarperCollins, New York.

Tversky, A. and D. Kahneman, 1974. “Judgment under Uncertainty: Heuristics and Biases,” Science (American Association for the Advancement of Science) 185 (4157): 1124–1131.

Bruce Caldwell on Hayek versus Keynes

Bruce Caldwell is an economic historian, and a specialist on Hayek. This talk was part of a conference called The Economic Crisis and the Crisis in Economics, held at King’s College Cambridge, England (April 8-11, 2010). There is some interesting material here, both on the Keynes-Hayek relationship, and Hayek’s views on economics.

Monday, June 27, 2011

The Concept of “Animal Spirits” is a Red Herring

Keynes discussed the factors influencing long-run expectations in Chapter 12 of the General Theory (the chapter is entitled “The State of Long-Term Expectation”). As is well known, Keynes thought that business expectations are subjective, not objective in the sense that objective probabilities can be given about possible future events affecting investment.

Keynes used the expression “animal spirits” but three times in the whole General Theory, and all towards the end of Chapter 12, yet the concept seems to cause a considerable amount of confusion.

The relevant passage where the expression occurs is here:
“Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die;—though fears of loss may have a basis no more reasonable than hopes of profit had before.

It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death. (Keynes 2008 [1936]: 144).
The term “animal spirits” was borrowed by Keynes from Descartes (Gerrard 1994: 15), and it is obvious that Keynes did not seriously use it in the original sense of Descartes, to mean “the fiery particles of the blood distilled by the heat of the heart” (as quoted in Gerrard 1994: 15). Critics of Keynes complain that they don’t understand what he means by it. But unless such people are incapable of reading English, the definition is perfectly clear: Keynes uses “animal spirits” in the sense of “a spontaneous [human] urge to action rather than inaction.”

Now Austrians like Jerry O’Driscoll also complain about the use of the term, and also that Keynes’s “psychology was of the crudest” kind. The answer to all these complaints about the use of the phrase is rather obvious to me: all talk, and use, of the phrase and concept of “animal spirits” can be dropped entirely from Post Keynesian treatments of subjective expectations without any problem at all. Modern Post Keynesian subjective expectations theory has, anyway, developed itself by using ideas from contemporary psychology, and, even if Keynes’s psychology was crude, this is also irrelevant to the modern theory.

The concept of “animal spirits” as used by Keynes is not even necessary to the modern subjective expectations theory. So much of the discussion of Keynesian subjective expectations by Austrians descends into waving the concept of “animal spirits” around and complaining about it, when this is nothing but the red herring fallacy, the logical fallacy in which some irrelevant topic is invoked in order to divert attention from the original issue. What is more ridiculous is that most Austrians also adhere to the view that expectations are subjective.

Whether or not humans have a “spontaneous urge to action rather than inaction” is a matter for modern psychology, evolutionary psychology, neuroscience and cognitive science.

All that Keynes needed to say is that human beings can, and do, act in the face of uncertainty, whether that is real or perceived uncertainty. This statement that would be a synthetic proposition, whose truth can only be known a posteriori (i.e., by empirical evidence). Because of uncertainty about the future, expectations in the investment decision are not a matter of mathematical calculation.

In A Treatise on Probability (1921), Keynes had already dealt with the issue of probability, and had argued that under uncertainty the likelihood of future events came in different forms:
(1) that there are no probabilities at all (fundamental uncertainty),
(2) that there may be some partial ordering of probable events but no cardinal numbers can be placed on them,
(3) that there may be numbers but they cannot be discovered for some reason, and
(4) that there may be numbers but they are difficult to discover (Barkley Rosser 2001: 559).
By 1937, Keynes had come to stress the importance of uncertainty in the sense of (1) above in economic decision making:
“By ‘uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealthowners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever” (Keynes 1937: 213–214).
Expectations are subjective, and the investment decision is not rational (the word “rational” is here used in the sense of the neoclassical rational expectations hypothesis). Business people making investments are also influenced by what other business people are doing, and there can be general waves of optimism or pessimism. Keynes’ ideas on uncertainty and the consequences for expectations were taken up by G. L. S. Shackle (1952, 1955, 1969) and Post Keynesians (Dow and Hillard 1995; King 2002: 181-188; Dunn 2008: 69-116), and developed into the modern subjective expectations theory.

In essence, in conditions where a human makes a decision in the face of genuine uncertainty, he or she can (1) recognise that uncertainty or (2) fall into the trap of thinking they do not face uncertainty, perhaps by believing that they can provide objective probabilities for future outcomes. Either way most people have a propensity to act.

So what happens in the case of investment? People making investment decisions cannot know the future or give objective probabilities for many possible events affecting their decisions: uncertainty simply cannot be quantified in an objective, precise mathematical way. Their subjective expectations in the short or long run about the profitability and success of their investment influence the decision, and they are also influenced by what other people around them think.

Even a cursory reading of the specialist literature in modern cognitive and evolutionary psychology suggests to me that the Post Keynesians would have little difficulty in using modern theories to support their view of subjective expectations in the investment decision.
“Human beings make a vast numbers of decisions throughout their lives. Some of these have rather trivial consequences ... others have more far reaching repercussions ... In the 1970s Amos Tversky and Nobel Laureate Daniel Kahneman published some startling work suggesting that people are rather poor at making decisions in situations that involve some degree of uncertainty. In particular, Tversky and Kahneman proposed that much of our reasoning under uncertainty involves the use of heuristics. Heuristics are short-cut solutions to a problem, which are usually fast and easy to apply but which do not guarantee a correct solution” (Workman and Reader 2004: 230).
The “heuristic and biases” method of Tversky and Kahneman (1974; and Kahneman et al. 1982) described above appears to be a very useful approach which confirms and complements the Post Keynesian theory of business decision-making under uncertainty (Fontana 2009: 39–41). Keynes can be seen as having examined the heuristics and biases by which people in business make decisions about investment, with their use of instincts, conventions and habits of mind. But heuristics do not necessarily “guarantee a correct solution.” A decision not to invest might be wrong, just as a decision to invest can be in error. The cognitive bias in decision-making called the bandwagon effect is relevant to how investors and business people are caught up in the general state of expectations, how waves of optimism can cause more and more businesses to make investment decisions, or how financial markets are subject to rapid changes from bear to bull positions and vice versa.


Barkley Rosser, J. 2001. “Alternative Keynesian and Post Keynesian Perspectives on Uncertainty and Expectations,” Journal of Post Keynesian Economics 23.4: 545–566

Davidson, P. 1991. “Is Probability Theory Relevant for Uncertainty? A Post Keynesian Perspective,” Journal of Economic Perspectives 5.1: 129–143.

Dow, S. and J. Hillard (eds), 1995. Keynes, Knowledge and Uncertainty, E. Elgar Publishing Limited, Aldershot.

Dunn, S. P. 2008. The ‘Uncertain’ Foundations of Post Keynesian Economics, Routledge, London.

Fontana, G. 2009. Money, Uncertainty and Time, Routledge, London and New York.

Gerrard, B. 1994. “Animal Spirits,” in P. Arestis and M. Sawyer (eds), The Elgar Companion to Radical Political Economy, Elgar, Aldershot. 15–19.

Harcourt, G. C. and P. A. Riach (eds), 1997. A “Second Edition” of The General Theory (Vol. 1), Routledge, London.

Holt, R. P. F. and S. Pressman (eds). 2001. A New Guide to Post-Keynesian Economics, Routledge, London and New York.

Kahneman, D., Slovic, P. and A. Tversky (eds), 1982. Judgment Under Uncertainty: Heuristics and Biases Cambridge University Press, Cambridge.

Keynes, J. M. 1921 A Treatise on Probability (1st edn), Macmillan, London.

Keynes, J. M. 2008 [1936]. The General Theory of Employment, Interest, and Money, Atlantic Publishers, New Delhi.

Keynes, J. M. 1937. “The General Theory of Employment,” Quarterly Journal of Economics 51: 209–223.

King, J. E. 2002. A History of Post Keynesian Economics since 1936, Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

Koppl, R. 1991. “Retrospectives: Animal Spirits,” Journal of Economic Perspectives 5.3: 203–210.

O’Driscoll, Jerry, 2009. “Animal Spirits,” November 13

Runde, J. and S. Mizuhara (ed.), 2003. The Philosophy of Keynes’s Economics: Probability, Uncertainty and Convention, Routledge, London.

Shackle, G. L. S. 1952. Expectation in Economics (2nd edn), Cambridge University Press, Cambridge.

Shackle, G. L. S. 1955. Uncertainty in Economics: And Other Reflections, Cambridge University Press, Cambridge.

Shackle, G. L. S. 1958. Time in Economics (Professor Dr. F. de Vries lectures, 1957), North-Holland Pub. Co., Amsterdam.

Shackle, G. L. S. 1969 Decision, Order and Time in Human Affairs (2nd edn), Cambridge University Press, London.

Shackle, G. L. S. 1976. Time and Choice (Keynes lecture in Economics, 1976), British Academy, London.

Shackle, G. L. S. 1988. Business, Time and Thought: Selected Papers of G.L.S. Shackle (ed. S. F. Frowen), Macmillan, Basingstoke.

Shackle, G. L. S. 1990. Time, Expectations and Uncertainty in Economics: Selected Essays of G. L. S. Shackle (ed. J. L. Ford), Elgar, Aldershot.

Tversky, A. and D. Kahneman, 1974. “Judgment under Uncertainty: Heuristics and Biases,” Science (American Association for the Advancement of Science) 185 (4157): 1124–1131.

Workman, L. and W. Reader. 2004. Evolutionary Psychology: An Introduction, Cambridge University Press, Cambridge, UK and New York.

Saturday, June 25, 2011

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!


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.

Friday, June 24, 2011

Stagflation in the 1970s: A Post Keynesian Analysis

The portmanteau word “stagflation” (stagnation + inflation) refers to the economic problems of the 1970s. We need a clear definition of stagflation, and there are in fact two senses in which it is used:
(1) the simultaneous occurrence of stagnation (low or no growth) and high inflation (the original definition of the term when it was coined by Ian Macleod, in a speech to the British House of Commons, in 1965);

(2) the simultaneous occurrence of rising unemployment rates and rising inflation.
It is sense (2) in which the word is normally used in economics, and it describes high unemployment and high inflation rates (even during recessions) occurring simultaneously. Thus the years from 1975-1977 in the US were not technically stagflation: these were years of an expansion in the business cycle with disinflation (falling inflation rates), rising employment, and rising real output growth.

The most serious periods of stagflation were in 1973–1974/1975 and 1979-1981 when many countries entered recessions and experienced rising unemployment and rising inflation. In most countries, these severe years of surging inflation and unemployment were the result of the first (1973-1974) and second oil shocks (1979-1980), and the double digit inflation rates in many countries (though not all) that provoked the sense of crisis in these years were caused by the high price of energy, a major factor input. But it is also true that from 1968–1970 many countries experienced an unusual rise in wages and prices, with further surges in prices from 1972-1973 before the first oil shock hit their economies. This requires an explanation.

There is no doubt that the era of stagflation was a theoretical and practical problem for neoclassical synthesis Keynesians, with their flawed Hicksian IS-LM models.

But Post Keynesians never had any difficulty explaining stagflation and offering effective cures for it. In particular, Geoff Harcourt explains in the video below (from 20.00 minutes onwards) how Keynes’s General Theory was easily capable of showing that rising unemployment can occur with rising inflation. Harcourt also talks about Lorie Tarshis and his textbook summary of Keynes’s General Theory for American universities in the 1940s, which was attacked by conservatives. Tarshis’s accurate summary of Keynes was rejected for Paul Samuelson’s neoclassical version of Keynesianism (the neoclassical synthesis), and if Tarshis’s book on Keynes had been used instead of Samuelson’s textbook, many of the theoretical problems of neoclassical synthesis Keynesianism would have been avoided.

One of the best analyses of stagflation is by Nicholas Kaldor:
“Inflation and Recession in the World Economy,” Economic Journal 86 (December, 1976): 703–714.
My analysis here is based on Kaldor and other Post Keynesian work.

When we buy many commodities we do not engage in some kind of haggling over price in each individual transaction, or compete with others to bid for a product as in an auction, nor do the prices of many commodities change even though demand has changed. For example, when you go to the supermarket, you do not see daily or weekly fluctuations in the price of milk or bread in accordance with demand for, and sales of, those commodities.

Real world capitalism has developed numerous markets where prices are not set, or explicable, by demand and supply curves. Instead, prices can be (1) administered by business institutions or (2) cooperation between businesses that produce commodities (the familiar concepts of monopoly, oligopoly and cartels). But modern corporations are often institutions that also administer prices, and prices can be stable or unchanged for significant periods of time. Nor do they not respond immediately to demand or sales fluctuations:
“In studies of price determination, business enterprises have stated that variations of their prices within practical limits, given the prices of their competitors, produced virtually no change in their sales and that variations in the market price, especially downward, produced little if any changes in market sales in the short term. Moreover, when the price change is significant enough to result in a significant change in sales, the impact on profits has been negative enough to persuade enterprises not to try the experiment again. Consequently administered prices are maintained for a variety of different outputs over time … The pricing administrators of business enterprises maintain pricing periods of three months to a year in which their administered prices remained unchanged; and then, at the end of the period, they decide on whether to alter them.” (Lee 2003: 288).
What disturbs this?

The price of commodities produced in an economy depends on the costs of factors of production, in particular the wage bill, and then the mark-up over the costs of factor inputs (Musella and Pressman 1999: 1100).

The factors of production are
(1) primary commodities or natural resources, including land, raw materials, water, and energy;
(2) labour, and
(3) capital goods.
Thus inflationary pressures can result from
(1) surges in the prices of primary commodities or energy, especially when the prices of these factor inputs are set on world markets or are influenced by supply shocks;

(2) workers pushing for wage rises, and

(3) business firms increasing their pricing mark-ups.
A vicious circle can result when (a) workers demand wage rises and then (b) firms increase their mark-ups, causing a circle of (a), (b) etc. The distinction must also be made between (1) demand-pull inflation, and (2) cost-push inflation, when the latter has a supply-side cause.

During the most of the Golden Age of Capitalism (1945–1973), primary commodity buffer stocks had ensured price stability. But this policy was changed in the 1960s when the US modified its buffer stock polices:
“… the duration and stability of the post-war economic boom owed a great deal to the policies of the United States and other governments in absorbing and carrying stocks of grain and other basic commodities both for price stabilisation and for strategic purposes. Many people are also convinced that if the United States had shown greater readiness to carry stocks of grain (instead of trying by all means throughout the 1960s to eliminate its huge surpluses by giving away wheat under PL 480 provisions and by reducing output through acreage restriction) the sharp rise of food prices following upon the large grain purchases by the U.S.S.R. [in 1972–1973], which unhinged the stability of the world price level far more than anything else, could have been avoided.” (Kaldor 1976: 228).
From 1968–1971 there were the beginnings of inflationary pressures, in both wages and prices in many industrialised nations. Around 1968–1969, this was reflected in wage rises in Japan, France, Belgium and the Netherlands, and from 1969–1970 in Germany, Italy, Switzerland and the UK, which Kaldor attributes to demands by unions for wage rises (Kaldor 1976: 224). There is of course an eternal struggle in modern capitalism between labour and capital over distribution of income, and sometimes this can get out of control. Post Keynesians recognise the need for some kind of control over wages in modern capitalism, when wage gains become excessive, and the method required is incomes policy of some type. This does not require hostility or opposition to trade unions, however, and Post Keynesian labour theory is, if anything, supportive of organised labour.

But the prelude to stagflation was also marked by a significant explosion in commodity prices that occurred in the second half of 1972. Part of the problem was the failure of the harvest in the old Soviet Union in 1972–1973 and the unexpectedly large purchases on world markets by the Soviet state. That was exacerbated by the uncertainty caused by the break up of the Bretton Woods system,
after Richard Nixon had ended the convertibility of the US dollar to gold on August 15, 1971, an event you can see Nixon announcing in the video below.

The end of Bretton Woods (the post-WWII international monetary system) was momentous: inflation expectations and instability on financial and commodity markets resulted, as well as a rise in commodity speculation as a hedge against inflation. This contributed to the cost-push inflation that was being felt in many countries after 1971. As Kaldor noted, this could have been averted had the United States not dismantled its commodity buffer stock in the 1960s.

The final factor that caused the severe inflation of the 1970s was the first oil shock from October 1973, when various Middle Eastern producers of oil instituted an embargo that lasted until March 1974 (Kaldor 1976: 226). In most countries, the double digit inflation of the 1970s was caused by the oil shocks. This fed into wage-price spirals in a number of countries.

A long-term solution to stagflation proposed by Kaldor was an international system of buffer stocks in major commodities. This could be used to raise commodity prices when they fell to too low a level by buying on the market (which would help incomes in developing nations and other producing nations), and to lower prices by selling into the market when prices were rising too high (Kaldor 1976: 228–229).

In short, Post Keynesian economics can easily understand and deal with stagflation. The wage-price spirals that broke out by the end of the 1960s in some industrialised nations could have been dealt with by incomes policy (national wage arbitration/wage-price controls), and the long-term solution was, and still is, an international system of commodity buffer stocks.


Blaas, W. 1982. “Institutional Analysis of Stagflation,” Journal of Economic Issues 16.4: 955-975.

Cornwall, J. 1990. The Theory of Economic Breakdown: An Institutional-Analytical Approach, Blackwell, Cambridge, MA.

Cornwall, J. 1994. Economic Breakthrough & Recovery: Theory and Policy (rev. edn), M.E. Sharpe, Armonk, N.Y.

Eckstein, A. and D. Heien, 1978. “The 1973 Food Price Inflation,” American Journal of Agricultural Economics 60.2: 186–196.

Galbraith, J. K. 2008. The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too, Free Press, New York.

Hathaway, D. E. 1974. “Food Prices and Inflation,” Brookings Papers on Economic Activity Vol. 1974, No. 1: 63–116.

Kaldor, N. 1976. “Inflation and Recession in the World Economy,” Economic Journal 86 (December): 703–714.

King, J. E. 2002. A History of Post Keynesian Economics since 1936, Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

Lee, F. S. 2003. “Pricing and Prices,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics, E. Elgar Pub., Cheltenham, UK and Northhampton, MA. 285–289.

Musella, M. and S. Pressman. 1999. “Stagflation,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy: L–Z, Routledge, London and New York. 1099–1100.

Milton Friedman on ABCT

Milton Friedman, the developer of the macroeconomic theory of monetarism, and himself a supporter of free market economics, was interviewed in Barron’s in 1998 (August 24), and gave his opinion of ABCT. Friedman’s comments are available on
“... I think the Austrian business-cycle theory has done the world a great deal of harm. If you go back to the 1930s, which is a key point, here you had the Austrians sitting in London, Hayek and Lionel Robbins, and saying you just have to let the bottom drop out of the world. You’ve just got to let it cure itself. You can’t do anything about it. You will only make it worse. You have Rothbard saying it was a great mistake not to let the whole banking system collapse. I think by encouraging that kind of do-nothing policy both in Britain and the United States, they did harm.”

Jeff Scott, “Business Cycles,” September 6, 1998.
While I don’t think much of Friedman’s monetarism, here he is quite correct.

In 1929, America faced a collapsing asset bubble. While the limited interventions of Hoover did very little to counteract the slump that followed, Hoover at least did not engage in large cuts to government spending (or at least did not try to balance the budget until fiscal year 1933). An “Austrian” policy of dismantling government and complete privatisation (anarcho-capitalism) or savage government spending cuts and abolition of the central bank (in some types of Misesian Classical liberalism) would have collapsed the US economy to an even greater extent than its contraction from 1929–1933.

To see how much harm deflationary austerity did, one only has to turn to what happened in Weimar Germany:
“Economic breakdown [sc. in Germany during the Great Depression] led to political upheaval which in turn destroyed the international status quo. Germany was the most striking example of this complex interaction. Without the depression Hitler would not have gained power. Mass unemployment reinforced all the resentments against Versailles and the Weimar democracy that had been smouldering since 1919. Overnight the National Socialists were transformed into a major party; their representation in the Reichstag rose from 12 deputies in 1928 to 107 in 1930. The deflationary policies of the Weimar leaders sealed the fate of the Republic” (Adamthwaite 1977: 34).
It is interesting that Friedrich von Hayek, to his credit, actually changed his mind on the effects of US deflation in 1929–1933, at least later in life:
“There is no doubt, and in this I agree with Milton Friedman, that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation! So, once again, a badly programmed monetary policy prolonged the depression” (Pizano 2009: 13).
In Hayek’s view, a secondary deflation had negative effects on the US economy after 1929 and his mea culpa is worth quoting:
“Although I do not regard deflation as the original cause of a decline in business activity, such a reaction has unquestionably the tendency to induce a process of deflation – to cause what more than 40 years ago I called a ‘secondary deflation’ – the effect of which may be worse, and in the 1930s certainly was worse, than what the original cause of the reaction made necessary, and which has no steering function to perform. I must confess that forty years ago I argued differently. I have since altered my opinion – not about the theoretical explanation of the events, but about the practical possibility of removing the obstacles to the functioning of the system in a particular way” (Hayek 1978: 206).

Adamthwaite, A. P. 1977. The Making of the Second World War, Allen & Unwin, London and Boston.

Hayek, F. A. 1978. New Studies in Philosophy, Politics, Economics and the History of Ideas, Routledge & Kegan Paul, London.

Pizano, D. 2009. Conversations with Great Economists, Jorge Pinto Books Inc., New York.

Thursday, June 23, 2011

Mises’s Three Concepts of Equilibrium

Equilibrium can be a tricky subject, as different economists have different definitions of the concept. Mises employs 3 different concepts, as follows:
“[sc. Mises] posits not one, but three notions of equilibrium that he claims underlie his analysis. The first, the ‘plain state of rest,’ is a temporary state in which all currently desired transactions have been made and, for the moment, no one wants to trade. His example of such a state is the close of the trading day in the stock market ....

The second equilibrium notion Mises employs is the “final state of rest,” the state toward which the market tends if there is no change in the data. This apparently is Mises’ analogue to general equilibrium. Whereas the plan state of rest is a phenomenon that is routinely found in markets, the final state of rest is an “imaginary construction” in that it can never be achieved in reality, although it is a necessary analytic tool for understanding the direction of price changes.

Finally, Mises posits yet a third equilibrium notion, the “evenly rotating economy,” or the “ERE.” This, too, is an imaginary construction of what the market would be like if there were no changes in the data. In this construction, however, people continue to be born, to live and to die, and capital is accumulated at a rate just sufficient to maintain current patterns of consumption and investment. It is a condition in which the same products are consumed and produced over and over again, and all prices equal the prices established in the final state of rest .... Whereas the first two notions have their analogues in contemporary economics, the ERE seems to be unique to Mises.” (Vaughn 1994: 81–82).
Mises describes the nature of money in the ERE:
“Then there is a second deficiency. In the imaginary construction of an evenly rotating economy, indirect exchange and the use of money are tacitly implied. But what kind of money can that be? In a system without change in which there is no uncertainty whatever about the future, nobody needs to hold cash. Every individual knows precisely what amount of money he will need at any future date. He is therefore in a position to lend all the funds he receives in such a way that the loans fall due on the date he will need them. Let us assume that there is only gold money and only one central bank. With the successive progress toward the state of an evenly rotating economy all individuals and firms restrict step by step their holding of cash and the quantities of gold thus released flow into nonmonetary—industrial—employment. When the equilibrium of the evenly rotating economy is finally reached, there are no more cash holdings; no more gold is used for monetary purposes. The individuals and firms own claims against the central bank, the maturity of each part of which precisely corresponds to the amount they will need on the respective dates for the settlement of their obligations. The central bank does not need any reserves as the total sum of the daily payments of its customers exactly equals the total sum of withdrawals. All transactions can in fact be effected through transfer in the bank’s books without any recourse to cash. Thus the ‘money’ of this system is not a medium of exchange; it is not money at all; it is merely a numeraire, an etheral and undetermined unit of accounting of that vague and indefinable character which the fancy of some economists and the errors of many laymen mistakenly have attributed to money. The interposition of these numerical expressions between seller and buyer does not affect the essence of the sales; it is neutral with regard to the people’s economic activities. But the notion of a neutral money is unrealizable and inconceivable in itself. If we were to use the inexpedient terminology employed in many contemporary economic writings, we would have to say: Money is necessarily a ‘dynamic factor’; there is no room left for money in a ‘static’ system. But the very notion of a market economy without money is self-contradictory.” (Mises 1996: 249)
The ERE was not used by Hayek as his equilibrium model in Prices and Production, although there are of course similarities (and the ERE does appear in later Hayekian versions of ABCT). I do not think Wicksell’s model in his monetary equilibrium theory is an ERE either (if readers think I am wrong, I would like to hear why).

Hayek makes it clear in Prices and Production that he working in the general equilibrium tradition, which would be Mises’s “final state of rest”:
“it is my conviction that if we want to explain economic phenomena at all, we have no means available but to build on the foundations given by the concept of a tendency toward an equilibrium. For it is this concept alone which permits us to explain fundamental phenomena like the determination of prices or incomes, an understanding of which is essential to any explanation of fluctuation of production. If we are to proceed systematically, therefore, we must start with a situation which is already sufficiently explained by the general body of economic theory. And the only situation which satisfies this criterion is the situation in which all available resources are employed.” (Hayek 2008: 225).
Wicksell had already used Walras’ theory of general equilibrium and combined it with Bohm Bawerk’s theory of interest, to try and establish the conditions of monetary equilibrium (Loasby 1998: 54). Hayek developed an intertemporal equilibrium theory in 1928 in his paper “Intertemporal Price Equilibrium and Movement in the Value of Money” (Hayek 1984 [1928]), but did not use this in Prices and Production. Instead, “he reverted to the stationary equilibrium approach, by adopting the simple stationary-equilibrium model put forward by Wicksell in Interest and Money as the starting point for his analysis” (Donzelli 1993: 57). This was a stationary equilibrium model:
“Wicksell’s theory of monetary equilibrium, whose influence was to be crucial, was built on the foundations of his critique of the Quantity Theory. He effectively believed that the velocity of circulation of money proper was unstable since, under certain institutional conditions, it is possible to reduce the use of money through control of credit and thus to affect its velocity of circulation. The demand for credit of the banking system is governed by the difference between two rates: the supply price of bank credit, or money rate of interest, and a rate which Wicksell defined first as a ‘natural rate’, which would equalise savings and investment in an economy without money, and then as a ‘normal’ rate: the equilibrium interest rate on loanable funds in a monetary economy …. Hayek retained the idea of a disparity between these rates as a driving force behind the processes of expansion and contraction, as well as the role of credit in allowing a demand for produced and non-produced investment goods in excess of voluntary savings. Demand is then pushed above the value of goods supplied, leading to increased prices and a rationing of consumers – a forced saving. Equality of these interest rates represents monetary equilibrium.” (Hénin 1986: 39)

Donzelli, F. 1993. “The Influence of the Socialist Calculation Debate on Hayek’s view of general equilibrium theory,” Revue Européenne des Sciences 31.96.3: 47–83.

Hayek, F. A. 1984 [1928]. “Intertemporal Price Equilibrium and Movement in the Value of Money,” in R. McCloughry (ed.), Money, Capital and Fluctuations. Early Essays, Routledge & Kegan Paul, London.

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.

Hénin, P.-Y. 1986. Macrodynamics: Fluctuations and Growth: A Study of the Economy in Equilibrium and Disequilibrium, Routledge & Kegan Paul, London.

Loasby, B. J. 1998. “Co-ordination Failure: Economic Theory in the 1930s,” in P. Fontaine and A. Jolink (eds), Historical Perspectives on Macroeconomics: Sixty Years After the General Theory, Routledge, London. 53–64.

Mises, L. 1996. Human Action: A Treatise on Economics (4th revised edn), Mises Institute, Auburn, Ala.

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

Hayek and the Myth of Neutral Money

Hayek’s version of the Austrian trade cycle theory adopted the Wicksellian notion of “neutral money.” This appears to have been one of Hayek’s fundamental ideas in developing the trade cycle theory, and he presents his case for neutral money as a concept in a 1928 essay:
Hayek, F. A. von, 1928. “Das Intertemporale Gleichgewichtssystem der Preise und die Bewegungen des Geldwertes,” Weltwirtschaftliches Archiv 2: 33–76.
The extent to which Hayek urged neutral money as a actual monetary policy is unclear. But, as late as 1933, Hayek appeared to be still urging the idea of attempting to make money neutral (or, that is to say, trying to implement monetary policy that would approach the situation of “neutral money”), though he is not as optimistic about it:
Hayek, F. A. von, “Über ‘neutrales Geld,’” Zeitschrift fur Nationalökonomie 4 (1933): 659–661, translated in F. A. von Hayek, Money, Capital & Fluctuations: Early Essays (ed. R. McCloughry), Routledge & Kegan Paul, London, 1984.
Hayek had already come up against the critique of Sraffa in 1932 and by the time of the 2nd edition of Prices and Production (2nd edn; Routledge and Kegan Paul, 1935) he was starting to distance himself from neutral money, and admitting it was never a practical monetary policy.

And by the time of Denationalisation of Money: The Argument Refined. An Analysis of the Theory and Practice of Concurrent Currencies (1990; 1st edn 1976), Hayek is quite clear that any attempt to create neutral money in the real world is pointless:
“Although I have myself given currency to the expression ‘neutral money’ (which, as I discovered later, I had unconsciously borrowed from Wicksell), it was intended to describe this almost universally made assumption of theoretical analysis and to raise the question whether any real money could ever possess this property, and not as a model to be aimed at by monetary policy. I have long since come to the conclusion that no real money can ever be neutral in this sense, and that we must be content with a system that rapidly corrects the inevitable errors.” (Hayek 1990: 87–88).
Sraffa is vindicated:
“The starting-point and the object of Dr. Hayek’s inquiry is what he calls ‘neutral money’; that is to say, a kind of money which leaves production and the relative prices of goods, including the rate of interest, ‘undisturbed,’ exactly as they would be if there were no money at all. This method of approach might have something to recommend it, provided it were constantly kept in mind that a state of things in which money is ‘neutral’ is identical with a state in which there is no money at all: as Dr. Hayek once says, if we ‘eliminate all monetary influences on production ... we may treat money as non-existent’” [Prices and Production, p. 109]. .... (Sraffa 1932: 42).

Hayek, F. A. von, 1928. “Das Intertemporale Gleichgewichtssystem der Preise und die Bewegungen des Geldwertes,” Weltwirtschaftliches Archiv 2: 33–76.

Hayek, F. A. von, 1933. “Über ‘neutrales Geld,’” Zeitschrift fur Nationalökonomie 4: 659–661.

Hayek, F. A. von, 1984. Money, Capital & Fluctuations: Early Essays (ed. R. McCloughry), Routledge & Kegan Paul, London.

Hayek, F. A. von, 1990. Denationalisation of Money: The Argument Refined. An Analysis of the Theory and Practice of Concurrent Currencies (3rd edn; 1st edn 1976), The Institute of Economic Affairs, Westminster, London.

Sraffa, P. 1932. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.

The Differences Between Mises and Hayek on ABCT

In “An Interview with Israel M. Kirzner,” Austrian Economics Newsletter (vol. 17.1, 1997), Kirzner has this to say about Austrian business cycle theory (ABCT):
AEN: You’ve never thought of providing a systematic critique of the Austrian business cycle theory, for instance?

KIRZNER: No, I’ve never had too much interest in the Austrian business cycle theory. I’ve never felt that the Hayekian business cycle theory was essentially Austrian. In fact, Mises, who was the originator of this whole idea in 1912, didn’t see it as particularly Austrian either. There are passages where he notes that people call it the Austrian theory, but he says it’s not really Austrian. It goes back to the Currency School and Knut Wicksell. It’s certainly not historically Austrian. Further, I would claim that, as developed by Hayek, there are many aspects of it that are non-Austrian. I don’t believe that to be an Austrian you have to buy into the Hayekian view of business cycles. …..

AEN: And the rest of the theory?

KIRZNER: Otherwise, the Austrian theory of the business cycle is a macro theory. It’s an equilibrium theory. And it treats capital in an objective sense rather than a subjective sense. It treats time as somehow embedded in the capital goods themselves. So I’ve always had a certain reserve about that particular theory, however brilliant it may be. I think the way Hayek developed it was not quite consistent with the way Mises laid it out in 1912.”
“An Interview with Israel M. Kirzner,” Austrian Economics Newsletter (vol. 17.1, 1997).
What does Kirzner mean by the statement: “I think the way Hayek developed it was not quite consistent with the way Mises laid it out in 1912”?

The answer is, I think, provided by Alan O. Ebenstein:
“in England during the early 1930s, it was Hayek, not Mises, who was the actor, and it was Hayek’s work that become known as Austrian business cycle theory. Even later, Mises did not adopt as his own Hayek’s theory that depressions and recessions are primarily caused by real changes in the structure of production. Mises wrote in Human Action (1949) of his own ‘monetary or circulation credit theory of the trade cycle’: ‘The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.’ Mises’s main point was that excessive monetary expansion leads to inflationary collapse, not Hayek’s thesis that excessive monetary expansion misshapes the structure of production. What were paragraphs in Mises’s thought became books in Hayek’s. It could be the case that Mises’s oral teaching was slightly different from his written work, and it is possible that in his lectures he may have given more emphasis, as Hayek did, to relative price relations that are disturbed by credit manipulation as well as to changes in the general price level. If so, there would be more congruity between Mises’s and Hayek’s business cycle theories.” (Ebenstein 2005: 52–53).
There is thus the possibility that in Mises’s lectures and personal conversations his version of the trade cycle theory was developing and diverging from his published work, where his version of the ABCT remained different from Hayek’s. Hayek might seem to confirm this:
“One episode in the growth of my expositions may perhaps be worth recording here. In the draft of my account of American monetary policy after 1920 I had made use of what I thought was a theory of Ludwig von Mises that was familiar to us in the Vienna circle. But another member of our group with whom I was in daily contact, Gottfried Haberler, persuaded me after reading my first draft that no sufficient exposition of the theory I had used was to be found in Mises’s published work, and that if I was to expect to be understood, I must give a fuller account of the theory underlying my report of the events described. Thus arose the long footnote ... containing the first statement of my version of Mises’ theory.” (Hayek 1984: 2–3).
In light of all this, one should be aware that Mises’s published versions of ABCT are not quite the same as Hayek’s, and do not emphasise the structure of production distortions imagined by Hayek.


Ebenstein, A. O. 2005. Hayek’s Journey: The Mind of Friedrich Hayek, Palgrave Macmillan, New York.

Hayek, Friedrich A. von, 1984, “Introduction,” in R. McCloughry (ed.), Money, Capital & Fluctuations: Early Essays, Routledge & Kegan Paul, London.

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

Tuesday, June 21, 2011

Keynes on the End of the Gold Exchange Standard

As is well known, Britain returned to the gold standard after World War I at an exchange rate that was far too high, and this made British exports uncompetitive. The 1920s were a period of high unemployment and economic malaise in Britain. Then the Great Depression struck.

On September 19, 1931, the UK left the gold exchange standard. There is a wonderful little video below of Keynes taking about that event.

Ludwig von Mises, one of the leading Austrian economists of that era, made a prediction about what would happen, and this story is told by Mark Skousen:
“In September 1931, Ursula Hicks (wife of John Hicks) was attending Mises’ seminar in Vienna when England suddenly announced it was going off the gold exchange standard. Mises predicted the British pound would be worthless within a week, which never happened. Thereafter, Mises always expressed deep skepticism about the ability of economists to forecast.” (Skousen 2009: 286, n. 2).
I am not surprised that Skousen relegates this embarrassing story to a footnote. So much for Mises’s great predictive powers.

Keynes, by contrast, was correct in predicting that British trade would benefit from abandoning the gold exchange standard and from the currency depreciation that resulted. He was also correct in opposing the gold standard fanatics like Mises who predicted the collapse of the value of the pound. In our era, the Austrians have been predicting hyperinflation, but they are as contemptibly and stupidly wrong as Mises was in 1931.


Skousen, M. 2009. The Making of Modern Economics: The Lives and Ideas of the Great Thinkers (2nd edn.), M.E. Sharpe, Armonk, N.Y.

Mises’s “Originary Interest Rate” Theory

Mises uses the Wicksellian natural interest rate in his earlier work on Austrian business cycle theory. But, by the time of Human Action (1949), Mises is employing an “originary interest rate” concept, and talk of the natural rate largely disappears. Mises explains the theory:
“Originary interest is the ratio of the value assigned to want-satisfaction in the immediate future and the value assigned to want-satisfaction in remote periods of the future. It manifests itself in the market economy in the discount of future goods as against present goods. It is a ratio of commodity prices, not a price in itself. There prevails a tendency toward the equalization of this ratio for all commodities. In the imaginary construction of the evenly rotating economy the rate of originary interest is the same for all commodities” (Mises 1998: 523).
This means that the originary interest is a future discounted good exchanging for a present good of higher value.

In terms of capital goods, this presumably means the discounted value of future goods against present goods that are borrowed now for capital goods investment.

But this is really just another real theory of the interest rate where loans are imagined as occurring in natura, or in real commodities in an economy at full employment. Mises is still subject to Sraffa’s critique of Hayek.

Curiosuly, when we turn to Roger Garrison we find the explicit use of the Wicksellian natural rate, as in Hayek’s work:
“So named by Swedish economist Knut Wicksell, the natural rate of interest is the rate that reflects the underlying real factors. In macroeconomic terms as applied to a wholly private economy, it is the rate that governs the allocation of resources between current consumption and investment for the future. By keeping saving and investment in balance, the natural rate guides the economy along a sustainable growth path. That is, governed by the natural rate, unconsumed current output (real saving) is used for augmenting the economy’s productive capacity in ways that are consistent with people’s willingness to postpone consumption. In the hands of the Austrian economists, the natural rate became the rate that reflects the time preferences of market participants and allocates resources among the temporally defined stages of production. The output of one stage serves as input to the next in this logical and broadly descriptive representation of the economy’s production process. The temporal dimension of the economy's capital structure is a key macroeconomic variable in Austrian theory. .... In summary terms, the natural rate is seen as an equilibrating rate. It is the rate that tells the truth about the availability of resources for meeting present and future consumer demands, allowing production plans to be kept in line with the preferred pattern of consumption. By implication, an unnatural, or artificial, rate of interest is a rate that reflects some extra-market influence and that creates a disconnection between intertemporal consumption preferences and intertemporal production plans” (Garrison 2006: 58–59).
So Garrison is also subject to same critique as Hayek. Yet in Garrison’s book Time and Money: The Macroeconomics of Capital Structure (London and New York, 2000), the word “Sraffa” does not (as far as I can see) even appear. It’s as if the Hayek–Sraffa exchange never occurred.


Garrison, R. W. 2000. Time and Money: The Macroeconomics of Capital Structure, Routledge, London and New York.

Garrison, R. W. 2006. “Natural and Neutral Rates of Interest in Theory and Policy Formulation,” Quarterly Journal of Austrian Economics 9.4: 57–68.

Garrison, Roger W. 2007. “Natural and Neutral Rates of Interest in Theory and Policy Formulation,” Mises Daily, April 21

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

Austrian Business Cycle Theory: The Various Versions and a Critique

I will set out here the various books and sources for Austrian business cycle theory (ABCT). The theory has been developed for nearly 100 years, but, nevertheless, it seems to me that all of them rely on a real rate of interest concept (whether that rate is called the natural rate of interest, originary rate, equilibrium rate, or pure rate of interest), and Wicksellian monetary equilibrium theory:
(1) The version of Mises in The Theory of Money and Credit (trans. J. E. Batson; Mises Institute, Auburn, Ala. 2009 [1953]), pp. 349–366. (It is unclear to me if this appears in the original German edition, Theorie des Geldes und der Umlaufsmittel [Munich and Leipzig, 1912] or the 2nd German edition published in 1924.)

(2) Mises’s version in Monetary Stabilization and Cyclical Policy (1928) in Mises 2006 [1978], The Causes of the Economic Crisis and Other Essays Before and After the Great Depression (Ludwig von Mises Institute, Auburn, Ala.), p. 99ff.

(3) The version of Mises in Human Action: A Treatise on Economics (Auburn, Ala., 1998), pp. 568–583.

(4) Hayek’s first version of ABCT in Prices and Production (London, 1931).

(5) Hayek’s second version of ABCT in Profits, Interest and Investment (London, 1939).

(6) Rothbard’s development of ABCT in Man, Economy, and State: A Treatise on Economic Principles (Ludwig von Mises Institute, Auburn, Ala., 2004 [1962]), pp. 994–1008; and in Economic Depressions: Their Cause and Cure (Ludwig von Mises Institute, Auburn, Ala. 2009 [1969]).

(7) M. Skousen’s interpretation in The Structure of Production (New York, 1990).

(8) Gerald P. O’Driscoll and Mario J. Rizzo in The Economics of Time and Ignorance (2nd edn; Routledge, Oxford, UK., 1996), pp. 198–213.

(9) The most recent developments of ABCT, as in Roger Garrison’s Time and Money: The Macroeconomics of Capital Structure (London and New York, 2000). A summary can be found in Garrison (1997).

(10) the exposition in Jesus Huerta de Soto, Money, Bank Credit and Economic Cycles (trans. M. A. Stroup; Ludwig von Mises Institute, Auburn, Ala, 2006), pp. 265–508.
They are all subject to these flaws:
(1) They assume a single real natural rate that does not exist in a growing, money-using economy, as Sraffa showed (1932a and 1932b). The natural rate is one that would obtain, as if loans were made in natura (that is, in real commodities). But in a barter economy not in equilibrium, there could be as many natural rates as there as commodities. As Rogers argues,
“The natural rate of interest is a real rate in the sense that it is supposedly determined in a market in which saving and investment are undertaken in natura. However, the fact is that in any but the most primitive economy no such ‘capital’ market exists, and the natural rate of interest, as envisaged by Wicksell and Robertson, does not exist either. The concept of the natural rate of interest is not merely non-operational: it is an abstract special case of no general theoretical significance. It cannot, therefore, provide the theoretical foundations for an operational loanable funds theory of the rate of interest” (Rogers 2001: 546).
(2) In Hayek’s version of ABCT in Prices and Production (London, 1931) he argued that policy should attempt to make money neutral (although by 1933 he was questioning whether monetary policy could ever approach the situation of “neutral money” [Hayek 1933: 159-162]). But money can never be made neutral, and a state in which money is neutral is nothing but a state in which money does not exist:
“The starting-point and the object of Dr. Hayek’s inquiry is what he calls ‘neutral money’; that is to say, a kind of money which leaves production and the relative prices of goods, including the rate of interest, ‘undisturbed,’ exactly as they would be if there were no money at all. This method of approach might have something to recommend it, provided it were constantly kept in mind that a state of things in which money is ‘neutral’ is identical with a state in which there is no money at all: as Dr. Hayek once says, if we ‘eliminate all monetary influences on production ... we may treat money as non-existent’” [Prices and Production, p. 109]. .... (Sraffa 1932a: 42).

“The money which he [viz., Hayek] contemplates is in effect used purely and simply as a medium of exchange. There are no debts, no money-contracts, no wage-agreements, no sticky prices in his suppositions. Thus he is able to neglect altogether the most obvious effects of a general fall, or rise, of prices” (Sraffa 1932a: 44).
(3) Wicksellian monetary equilibrium assumes an economy running at full employment, and Hayek in Prices and Production (1931) also makes this assumption. But in reality capitalist systems have historically had many periods when they are mired in underemployment disequilibria, or movements from one underemployment equilibrium to another, where there are significant idle resources, like labour, raw materials, capital goods and other factor inputs. If an economy with significant idle resources has investment via fractional reserve banking or central bank creation of excess reserves (without prior saving in loanable funds), how will the inflationary pressures imagined by ABCT happen if productive resources simply do not need to be freed in the stages close to consumption? Such factor inputs will be available or quickly made available through increasing capacity utilization in the relevant industries, or even imported from overseas. Even versions of ABCT (Huerta de Soto 2006: 440ff.) that reject the starting assumption of full employment fail to explain why the cycle effects would happen if in fact factor imputs were not scarce and available through international trade. Moreover, Mises, in “Monetary Stabilization and Cyclical Policy” (1928), is quite clear in saying that his cycle effects require that factor inputs have become scarce:
“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).
Mises still fails to address the issue of what would happen had the factor inputs or consumer goods not been scarce.

(4) The natural rate is conceived as an equilibrium interest rate that equilibrates loanable funds supply with demand for credit. In Wicksell’s natural rate of interest theory, this is supposed to be the interest rate where money supply is neutral, and where inflation does not occur.

But subjective expectations and the instability of investment are factors that destroy the myth of equilibrating markets, either the plan coordination imagined by Austrians or the full employment equilibrium concept of neoclassicals. These factors also destroy the basis of the view from loanable funds theory that, if there is an increase in saving, then the rate of interest would fall, which will stimulate investment in production by an equal amount. This idea that an increase in saving due to a fall in consumption would not decrease aggregate demand because there is a corresponding increase in investment in capital goods to compensate for the fall in consumption is an assumption underlying Say’s law, from which it is concluded that aggregate demand will remain the same and only its composition will alter. But subjective expectations in the investment decision destroy any such automatic process to create the necessary investment.

Garrison, R. W. 1997. “Austrian Theory of Business Cycles,” in D. Glasner and T. F. Cooley (eds), Business Cycles and Depressions: An Encyclopedia, Garland Pub., New York. 23–27.

Garrison, R. W. 2000. Time and Money: The Macroeconomics of Capital Structure, Routledge, London and New York.

Hayek, F. A. von, 1931. Prices and Production, G. Routledge & Sons, Ltd, London.

Hayek, F. A. von, 1935. Prices and Production (2nd edn), Routledge and Kegan Paul.

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

Hayek, F. A. von, 1941. The Pure Theory of Capital, Macmillan, London.

Hayek, F. A. von. 1984. Money, Capital & Fluctuations: Early Essays (ed. R. McCloughry), Routledge & Kegan Paul, London.

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

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

Mises, L. von. 1912 Theorie des Geldes und der Umlaufsmittel, Duncker & Humblot, Munich and Leipzig.

Mises, L. von. 1924. Theorie des Geldes und der Umlaufsmittel (2nd edn), Duncker & Humblot, Munich.

Mises, L. von. 1934. The Theory of Money and Credit (trans. H. E. Batson from 2nd German edition of 1924), J. Cape, London.

Mises, L. von. 1953. The Theory of Money and Credit (enlarged, new edn), Yale University Press, New Haven.

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.

O’Driscoll, G. P. and M. J. Rizzo, 1996. The Economics of Time and Ignorance (2nd edn), Routledge, Oxford, UK.

Rogers, C. 2001. “Interest rate: natural,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy. Volume 1. A–K, Routledge, London and New York. 545–547

Rothbard, M. N. 2004 [1962]. Man, Economy, and State: A Treatise on Economic Principles, Ludwig von Mises Institute, Auburn, Ala.

Rothbard, M. 2009 [1969]. Economic Depressions: Their Cause and Cure, Ludwig von Mises Institute, Auburn, Ala.

Skousen, M. 1990. The Structure of Production, New York University Press, New York.

Sraffa, P. 1932a. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.

Sraffa, P. 1932b. “A Rejoinder,” Economic Journal 42 (June): 249–251.

Monday, June 20, 2011

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.”

“… 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.


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.