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PART 3

APPLICATIONS

Equilibrium versus Market Process

Israel M. Kirzner

A characteristic feature of the Austrian approach to economic theory is its emphasis on the market as a process, rather than as a configuration of prices, qualities, and quantities that are consistent with each other in that they produce a market equilibrium situation.1 This feature of Austrian economics is closely bound up with dissatisfaction with the general use made of the concept of perfect competition. It is interesting to note that economists of sharply differing persuasions within the Austrian tradition all display a characteristic dissenchantment with the orthodox emphasis on both equilibrium and perfect competition. Thus Joseph A. Schumpeter’s well-known position on these matters is remarkably close to that of Ludwig von Mises.2 Oskar Morgenstern, in a notable paper on contemporary economic theory, expressed these same Austrian criticisms of modern economic theory.3

EQUILIBRIUM AND PROCESS

Ludwig M. Lachmann indicated that his own unhappiness with the notion of equilibrium primarily concerns the usefulness of the Walrasian general-equilibrium construction rather than that of the simple Marshallian partial-equilibrium construction.4 But it is precisely in the context of the simple short-run one-good market that I shall point out some of the shortcomings of the equilibrium approach.

In our classrooms we draw the Marshallian cross to depict competitive supply and demand, and then go on to explain how the market is cleared only at the price corresponding to the intersection of the curves. Often the explanation of market price determination proceeds no further—almost implying that the only possible price is the market-clearing price. Sometimes we address the question of how we can be confident that there is any tendency at all for the intersection price to be attained. The discussion is then usually carried on in terms of the Walrasian version of the equilibration process. Suppose, we say, the price happens to be above the intersection level. If so, the amount of the good people are prepared to supply is in the aggregate larger than the total amount people are prepared to buy. There will be unsold inventories, thereby depressing price. On the other hand, if price is below the intersection level, there will be excess demand, “forcing” price up. Thus, we explain, there will be a tendency for price to gravitate toward the equilibrium level at which quantity demanded equals quantity supplied.

Now this explanation has a certain rough-and-ready appeal. However, when price is described as being above or below equilibrium, it is understood that a single price prevails in the market. One uncomfortable question, then, is whether we may assume that a single price emerges before equilibrium is attained. Surely a single price can be postulated only as the result of the process of equilibration itself. At least to this extent, the Walrasian explanation of equilibrium price determination appears to beg the question.

Again, the Walrasian explanation usually assumes perfect competition, where all market participants are price takers. But with only price takers participating, it is not clear how unsold inventories or unmet demand effect price changes. If no one raises or lowers price bids, how do prices rise or fall?

The Marshallian explanation of the equilibrating process—not usually introduced into classroom discussion—is similar to the Walrasian but uses quantity rather than price as the principal decision variable.5 Instead of drawing horizontal price lines on the demand-supply diagram to show excess supply or unmet demand, the Marshallian procedure uses vertical lines to mark off the demand prices and the supply prices for given quantities. With this procedure the ordinate of a point on the demand curve indicates the maximum price at which a quantity (represented by the abscissa of the point) will be sold. If this price is greater than the corresponding supply price (the minimum price at which the same quantity will be offered for sale), larger quantities will be offered for sale. The reverse takes place when supply price exceeds demand price. In this way a tendency toward equilibrium is allegedly demonstrated to exist.

This procedure also assumes too much. It takes for granted that the market already knows when the demand price of the quantity now available exceeds the supply price. But disequilibrium occurs precisely because market participants do not know what the market-clearing price is. In disequilibrium “the” quantity is not generally known nor is the highest (lowest) price at which this quantity can be sold (coaxed from suppliers). Thus it is not clear how the fact that the quantity on the market is less than the equilibrium quantity assures the decisions of market participants to be so modified as to increase it.

Clearly neither of these explanations for the attainment of equilibrium is satisfactory. From the Austrian perspective, which emphasizes the role of knowledge and expectations, these explanations take too much for granted. What is needed is a theory of the market process that takes explicit notice of the way in which systematic changes in the information and expectations upon which market participants act lead them in the direction of the postulated equilibrium “solution.” The Austrian point of view does, in fact, help us arrive at such a theory.

ROBBINSIAN ALLOCATION AND MISESIAN ACTION

In developing a viable theory of market process it is helpful to call attention to the much-neglected role of entrepreneurship. The neglect of entrepreneurship in modern analysis is a direct consequence of the general preoccupation with final equilibrium positions. In order to understand the distinction between a process-conscious market theory, which makes reference to entrepreneurship, and an equilibrium market theory, which ignores entrepreneurship, it will help to compare the Misesian concept of human action with the Robbinsian concept of economizing, that is, allocative decision making.

It may be recalled that Lord Robbins defined economics as dealing with the allocative aspect of human affairs, that is, with the consequences of the circumstance that men economize by engaging in the allocation of limited resources among multiple competing ends.6 Mises, on the other hand, emphasized the much broader notion of purposeful human action, embracing the deliberate efforts of men to improve their positions.7 Both concepts, it should be noticed, are consistent with methodological individualism and embody the insight that market phenomena are generated by the interaction of individual decision makers.8 But the two constructions do differ significantly.

Robbinsian economizing consists in using known available resources in the most efficient manner to achieve given purposes. It entails the implementation of the equimarginal principle, that is, the setting up of an allocative arrangement in which it is impossible to transfer a unit of resource from one use to another and receive a net benefit. For Robbins, economizing simply means shuffling around available resources in order to secure the most efficient utilization of known inputs in terms of a given hierarchy of ends. It is the interaction in the market of the allocative efforts of numerous economizing individuals that generates all the phenomena that modern economics seeks to explain.

The difficulty with a theory of the market couched in exclusively Robbinsian terms is that in disequilibrium many of the plans of Robbinsian economizers are bound to be unrealized. Disequilibrium is a situation in which not all plans can be carried out together; it reflects mistakes in the price information on which individual plans were made. Market experience by way of shortages and surplus reveals the incorrectness of the original price expectations. Now the Robbinsian framework suggests that the unsuccessful plans will be discarded or revised, but we are unable to say much more than this. The notion of a Robbinsian plan assumes that information is both given and known to the acting individuals. Lacking this information market participants are blocked from Robbinsian activity altogether. Without some clue as to what new expectations will follow disappointments in the market, we are unable to postulate any sequence of decisions. All we can say is: if all the Robbinsian decisions dovetail, we have equilibrium; if they do not dovetail, we have disequilibrium. We lack justification within this framework for stating, for example, that unsold inventories will depress price; we may only say that with excessive price expectations Robbinsian decision makers will generate unsold inventories. As decision makers they do not raise or lower price; they are strictly price takers, allocating against a background of given prices. If all participants are price takers, how then can the market price rise or fall? By what process does this happen, if it happens at all?

In order for unsold inventories to depress price, market participants with unsold goods need to realize that the previously prevailing price was too high. Participants must modify their expectations concerning the eagerness of other participants to buy. But in order to make these assertions we must transcend the narrow confines of the Robbinsian framework. We need a concept of decision making wide enough to encompass the element of entrepreneurship to account for the way in which market participants change their plans. It is here that the Misesian notion of human action comes to our assistance.

Mises’s concept of human action embodies an insight about man that is entirely lacking in a world of Robbinsian economizers. This insight recognizes that men are not only calculating agents but are also alert to opportunities. Robbinsian theory only applies after a person is confronted with opportunities; for it does not explain how that person learns about opportunities in the first place. Misesian theory of human action conceives of the individual as having his eyes and ears open to opportunities that are “just around the corner.” He is alert, waiting, continually receptive to something that may turn up. And when the prevailing price does not clear the market, market participants realize they should revise their estimates of prices bid or asked in order to avoid repeated disappointment. This alertness is the entrepreneurial element in human action, a concept lacking in analysis carried out in exclusively Robbinsian terms. At the same time that it transforms allocative decision making into a realistic view of human action, entrepreneurship converts the theory of market equilibrium into a theory of market process.

THE ROLE OF ENTREPRENEURSHIP

There have, it is true, been other definitions of the entrepreneurial role. The principal views on the question have been those of Schumpeter, Frank H. Knight, and Mises. I have argued, however, that these alternative definitions upon analysis all have in common the element of alertness to opportunities.9 Alertness should be carefully distinguished from the mere possession of knowledge. And it is the distinction between being alert and possessing knowledge that helps us understand how the entrepreneurial market process systematically detects and helps eliminate error.

A person who possesses knowledge is not by that criterion alone an entrepreneur. Even though an employer hires an expert for his knowledge, it is the employer rather than the employee who is the entrepreneur. The employer may not have all the information the hired expert possesses, yet the employer is better “informed” than anyone else—he knows where knowledge is to be obtained and how it can be usefully employed. The hired expert does not, apparently, see how his knowledge can be usefully employed, since he is not prepared to act as his own employer. The hired expert does not perceive the opportunity presented by the possession of his information. The employer does perceive it. Entrepreneurial knowledge is a rarefied, abstract type of knowledge—the knowledge of where to obtain information (or other resources) and how to deploy it.

This entrepreneurial alertness is crucial to the market process. Disequilibrium represents a situation of widespread market ignorance. This ignorance is responsible for the emergence of profitable opportunities. Entrepreneurial alertness exploits these opportunities when others pass them by. G. L. S. Shackle and Lachmann emphasized the unpredictability of human knowledge, and indeed we do not clearly understand how entrepreneurs get their flashes of superior foresight. We cannot explain how some men discover what is around the corner before others do. We may certainly explain—on entirely Robbinsian lines—how men explore for oil by carefully weighing alternative ways of spending a limited amount of search resources, but we cannot explain how a prescient entrepreneur realizes before others do that a search for oil may be rewarding. As an empirical matter, however, opportunities do tend to be perceived and exploited. And it is on this observed tendency that our belief in a determinate market process is founded.

ADVERTISING AS AN ASPECT OF THE COMPETITIVE PROCESS

Characterization of the market process as one involving entrepreneurial discovery clarifies a number of ambiguities about the market and dispels several misunderstandings about how it functions. Advertising provides an excellent example on which to base our discussion.

Advertising, a pervasive feature of the market economy, is widely misunderstood and often condemned as wasteful, inefficient, inimical to competition, and generally destructive of consumer sovereignty. In recent years there has been somewhat of a rehabilitation of advertising in economic literature, along the lines of the economics of information. According to this view advertising messages beamed at prospective consumers are quantities of needed knowledge, for which they are prepared to pay a price. The right quantity of information is produced and delivered by the advertising industry in response to consumer desires. For reasons having to do with cost economy, it is most efficient for this information to be produced by those for whom such production is easiest, namely, by the producers of the products about which information is needed. There is much of value in this approach to an understanding of the economics of advertising, but it does not explain everything. The economics-of-information approach tries to account for the phenomena of advertising entirely in terms of the demand for and supply of nonentrepreneurial knowledge, information that can be bought and sold and even packaged. But such an approach does not go beyond a world of Robbinsian maximizers and fails to comprehend the true role of advertising in the market process.

Let us consider the producer of the advertised product. In his entrepreneurial role, the producer anticipates the wishes of consumers and notes the availability of the resources needed for a product to satisfy consumer desires. This function might appear to be fulfilled when the producer produces the product and makes it available for purchase. In other words, it might seem that the entrepreneur’s function is fulfilled when he transforms an opportunity to produce a potential product into an opportunity for the consumer to buy the finished product. Consumers themselves were not aware of the opportunities this production process represents; it is the superior alertness of the entrepreneur that has enabled him to fulfill his task. It is not sufficient, however, to make the product available; consumers must be aware of its availability. If the opportunity to buy is not perceived by the consumer, it is as if the opportunity to produce has not been perceived by the entrepreneur. It is not enough to grow food consumers do not know how to obtain; consumers must know that the food has in fact been grown! Providing consumers with information is not enough. It is essential that the opportunities available to the consumer attract his attention, whatever the degree of his alertness may be. Not only must the entrepreneur-producer marshal resources to cater to consumer desires, but also he must insure that the consumer does not miss what has been wrought. For this purpose advertising is clearly an indispensable instrument.

By viewing advertising as an entrepreneurial device, we are able to understand why Chamberlin’s distinction between fabrication costs and selling costs is invalid.10 Fabrication (or production) costs are supposedly incurred for producing a product, as distinguished from selling costs incurred to get buyers to buy the product. Selling costs allegedly shift the demand curve for the product, while the costs of fabrication (production) affect the supply curve only. The distinction has been criticized on the grounds that most selling costs turn out to be disguised fabrication costs of one type or another.11 Our perspective permits us to view the issue from a more general framework, which embodies the insight that all fabrication costs are at once selling costs as well. If the producer had a guaranteed market in which he could sell all he wanted of his product at a certain price, then his fabrication costs might be only fabrication costs and include no sum for coaxing consumers to buy it. But there never is a guaranteed market. The producer’s decisions about what product to produce and of what quality are invariably a reflection of what he believes he will be able to sell at a worthwhile price. It is invariably an entrepreneurial choice. The costs he incurs are those that in his estimation he must in order to sell what he produces at the anticipated price. Every improvement in the product is introduced to make it more attractive to consumers, and certainly the product itself is produced for precisely the same reasons. All costs are in the last analysis selling costs.

PROFITS AND THE COMPETITIVE PROCESS

The Austrian concept of the entrepreneurial role emphasizes profit as being the prime objective of the market process. As such it has important implications for the analysis of entrepreneurship in nonmarket contexts (such as within firms or under socialism or in bureaucracies in general). I have already remarked that we do not know precisely how entrepreneurs experience superior foresight, but we do know, at least in a general way, that entrepreneurial alertness is stimulated by the lure of profits. Alertness to an opportunity rests on the attractiveness of that opportunity and on its ability to be grasped once it has been perceived. This incentive is different from the incentives present in a Robbinsian world. In the nonentrepreneurial context, the incentive is constituted by the satisfactions obtainable at the expense of the relevant sacrifices. Robbinsian incentives are communicated to others by simply arranging that the satisfactions offered to them are more significant (from their point of view) than the sacrifices demanded from them. Incentive is thereby provided by the comparison of known alternatives. In the entrepreneurial context, however, the incentive to be alert to a future opportunity is quite different from the incentive to trade off already known opportunities; in fact it has nothing to do with the comparison of alternatives. No prior choice is involved in perceiving an opportunity waiting to be noticed. The incentive is to try to get something for nothing, if only one can see what it is that can be done.

Robbinsian incentives can be offered in nonmarket contexts. The bureaucrat, employer, or official offers a bonus for greater effort. For entrepreneurial incentives to operate, on the other hand, it is necessary for those who perceive opportunities to gain from noticing them. An outstanding feature of the market system is that it provides these kinds of incentives. Only by analysis of the market process does this very important entrepreneurial aspect of the market economy come into view. The real economic problems in any society arise from the phenomenon of unperceived opportunities. The manner in which a market society grapples with this phenomenon cannot be understood within an exclusively equilibrium theory of the market. The Austrian approach to the theory of the market therefore holds considerable promise. Much work still needs to be done. It would be good to know more about the institutional settings that are most conducive to opportunity discovery. It would be good to apply basic Austrian theory to the theory of speculation and of the formation of expectations with regard to future prices. All this would enrich our understanding of the economics of bureaucracy and of socialism. It can be convincingly argued that Mises’s famous proposition concerning economic calculation under socialism flows naturally from his “Austrianism.” Here, too, there is room for further elucidation. In all this agenda, the Austrian emphasis on process analysis should stand up very well.

NOTES

On the Central Concept of Austrian Economics: Market Process

Ludwig M. Lachmann

In setting up the market process as the central concept of Austrian economics, as opposed to the general-equilibrium approach of the neoclassical school, Austrian economists have a choice of strategies: They might, on the one hand, attempt to show the absurdity of the notion of general equilibrium, the arid formalism of the style of thought that gave rise to it, and its “irrelevance” to many urgent problems. They might, without denying the significance of equilibrating forces, stress the time aspect and show that the equilibrating forces can never do their work in time, that long before general equilibrium is established some change will supervene to render the data obsolete. They would, however, face the objection that the notion of market process requires equilibrating forces to make it work, an objection that, because it is a half-truth, might be hard to refute without drawing a distinction between “equilibrium of the individual” and “equilibrium of the economic system.”

In my view, however, Austrian economists should present their case for the market process by offering a fairly comprehensive account of the human forces governing it rather than by engaging in piecemeal discussions of its various interconnected aspects, which must, in the absence of the total picture, remain obscure. The defects of the neoclassical style become obvious if the Austrian economists simply point to facts the neoclassical conceptual tools are unable to explain.

What keeps the market process in perpetual motion? Why does it never end, denoting the final state of equilibrium of our system? If Austrian economists answered by saying, “Something unexpected always happens,” they would be accused of vagueness and reminded that only perpetual “changes in data” could have this effect. An attempt to show that continuous autonomous changes in demand or supply do account for the permanent character of the market process would involve a drawn-out discussion of the effects of ever-changing patterns of knowledge on the conduct of consumers and producers, a discussion in which Austrian economists would be at a serious disadvantage without prior elucidation of the term knowledge.

The market process is the outward manifestation of an unending stream of knowledge. This insight is fundamental to Austrian economics. The pattern of knowledge is continuously changing in society, a process hard to describe. Knowledge defies all attempts to treat it as a “datum” or an object identifiable in time and space.

Knowledge may be acquired at a cost, but is not always, as when we witness an accident or “learn by doing” for other than cognitive reasons. Sometimes, knowledge is jealously and expensively guarded; sometimes, it may be broadcast to reach a maximum number of listeners, as in advertising. Now knowledge, whether costly or free, may prove valuable to one and useless to another, owing to the complementarity of new and old knowledge and the diversity of human interests. Hence it is impossible to gauge the range of application of some bit of knowledge until it is obsolete. But we can never be certain that knowledge is obsolete since the future is unknown. All useful knowledge probably tends to be diffused, but in being applied for various purposes it also may change character, hence the difficulty of identifying it.

Knowledge then is an elusive concept wholly refractory to neoclassical methods. It cannot be quantified, has no location in space, and defies insertion into any complex of functional relationships. Though it varies in time, it is no variable, either dependent or independent. As soon as we permit time to elapse, we mustpermit knowledge to change, and knowledge cannot be regarded as a function of anything else. The state of knowledge of a society cannot be the same at two successive points of time, and time cannot elapse without demand and supply shifting. The stream of knowledge produces ever new disequilibrium situations, and entrepreneurs continually manage to find new price-cost differences to exploit. When one is eliminated by strenuous competition, the stream of knowledge throws up another. Profit is a permanent income from ever-changing sources.

Certain consequences of what has been said seem to concern the modus operandi of the market, but one appears to be significant for the methodology of all social sciences.

In the first place, how do we determine the true origin of any particular bit of knowledge? When and how do ill-founded surmises and half-baked ideas acquire the status of respectable knowledge? We can neither answer nor ignore these questions. Two things we may assert with reasonable confidence. As Karl Popper showed, we cannot have future knowledge in the present.1 Also, men sometimes act on the basis of what cannot really be called knowledge. Here we encounter the problem of expectations.

Although old knowledge is continually being superseded by new knowledge, though nobody knows which piece will be obsolete tomorrow, men have to act with regard to the future and make plans based on expectations. Experience teaches us that in an uncertain world different men hold different expectations about the same future event. This fact has certain implications for growth theory—in my view important implications—with which I deal in my paper “Toward a Critique of Macroeconomics” (included in this volume). Here we are concerned with the fact that divergent expectations entail incoherent plans. At another place I argued that “what keeps this process in continuous motion is the occurrence of unexpected change as well as the inconsistency of human plans. Both are necessary conditions.”2 Are we entitled, then, to be confident that the market process will in the end eliminate incoherence of plans which would thus prove to be only transient? What is being asked here is a fairly fundamental question about the nature of the market process.

The subject of expectations, a subjective element in human action, is eminently “Austrian.” Expectations must be regarded as autonomous, as autonomous as human preferences are. To be sure, they are modified by experience, but we are unable to postulate any particular mode of change. To say that the market gradually produces a consistency among plans is to say that the divergence of expectations, on which the initial incoherence of plans rests, will gradually be turned into convergence. But to reach this conclusion we must deny the autonomous character of expectations. We have to make the (diminishing) degree of divergence of expectations a function of the time sequence of the stages of the market process. If the stream of knowledge is not a function of anything, how can the degree of divergence of expectations, which are but rudimentary forms of incomplete knowledge, be made a function of time?

Unsuccessful plans have to be revised. No doubt planners learn from experience. But what they learn is not known; also different men learn different lessons. We might say that unsuccessful planners make capital losses and thus gradually lose their control over resources and their ability to engage in new enterprises; the successful are able to plan with more confidence and on a much larger scale. Mises used such an argument. But how can we be sure? History shows many examples of men who were “ahead of their times,” whose expectations were vindicated when it was too late, who had to give up the struggle for lack of resources when a few more would have brought them triumph instead of defeat. There is no reason why a man who fails three times should not succeed the fourth. Expectations are autonomous. We cannot predict their mode of change as prompted by failure or success.

What we have here is a difference of opinion on the nature of the market process. For one view the market process is propelled by a mechanism of given and known forces of demand and supply. The outcome of the interaction of these forces, namely, equilibrium, is in principle predictable. But outside forces in the form of autonomous changes in demand and supply continually impinge on the system and prevent equilibrium from being reached. The system is ever moving in the direction of an equilibrium, but it never gets there. The competitive action of entrepreneurs tending to wipe out price-cost differences is regarded as “equilibrating”; for in equilibrium no such differences could exist.

The other view, which I happen to hold, regards the distinction between external forces and the internal market mechanism as essentially misleading. Successive stages in the flow of knowledge must be manifest in both. Market action is not independent of expectations, and every expectation is an attempt “to catch a glimpse of future knowledge now.” To say that each market moves toward a price that “clears” it has little meaning where speculators are busy piling up and unloading stocks. The relationship between different markets in disequilibrium is infinitely complex. I shall say nothing more about it here, though I deal with some aspects of this complex problem in “Toward a Critique of Macroeconomics” (included in this volume).

Having set out to replace the paradigm of general equilibrium by that of the market process, why should we concentrate on the equilibrating nature of the latter—on showing that but for the perennial impact of external forces general equilibrium would be reached after all? It might be held, however, that every process must have a direction, and unless we are able to show that every stage of the market process “points” in the direction of equilibrium, no satisfactory theory of the market process is possible.

But this is not a convincing view. In the first place, though a process may have a direction at each point of time, it may change direction over time. The direction the process follows need not be the same throughout. Second and more important, two kinds of process have to be distinguished here. The first is a limited process, in the course of which we witness the successive modes of interaction of a set of forces, given initially and limited in number. Such a process may terminate or go on forever; whatever happens depends entirely on the nature of the (given) set of forces. The system may be subjected to random shocks from external sources, which it may take some time to absorb, such absorption interfering with the interaction of the forces. The second variety of process is the very opposite of the first. No initial set of forces delimits the boundaries of events. Any force from anywhere may at any time affect our process, and forces that impinged on it yesterday may suddenly vanish from the scene. There is no end or final point of rest in sight. Need I assert that history is a process of the second, not of the first, variety?

While our market process is not of the first kind, it is not completely unlimited. Two things may be said about it. The notion of general equilibrium is to be abandoned, but that of individual equilibrium is to be retained at all costs. It is simply tantamount to rational action. Without it we should lose our “sense of direction.” The market process consists of a sequence of individual interactions, each denoting the encounter (and sometimes collision) of a number of plans, which, while coherent individually and reflecting the individual equilibrium of the actor, are incoherent as a group. The process would not go on otherwise.

Walrasians, in using the same notion of equilibrium on the three levels of analysis—the individual, the market, and the entire system—succumbed to the fallacy of unwarranted generalization: they erroneously believed that the key that unlocks one door will also unlock a number of others. Action controlled by one mind is, as Mises showed, necessarily consistent. The actions of a number of minds in the same market lack such consistency, as the simultaneous presence of bulls and bears shows. Consistency of actions in a number of markets within a system constitutes an even greater presumption.

Finally, the divergence of expectations, apart from being an obstacle to equilibrium, has an important positive function in a market economy. It is an anticipatory device. The more extended the range of expectations, the greater the likelihood that somebody will catch a glimpse of things to come and be “right.” Those who take their orientation from the future rather than the present, the “speculators,” permit the future to make its impact on the market process earlier than otherwise. They contrive to inject a glimpse of future knowledge into the emergent market pattern. Of course they may make mistakes for which they will pay. Without divergent expectations and incoherent plans, however, it could not happen at all.

NOTES

The Theory of Capital

Israel M. Kirzner

It is not my purpose here to offer a concise Austrian theory of capital. Rather I shall present an Austrian perspective on several concepts fundamental to modern capital theory. I shall show how this perspective enables us to fit certain characteristically Austrian ideas about capital into the more comprehensive Austrian view of the way in which the market system operates. To clarify what constitutes the uniquely Austrian way of thinking about capital, I shall begin with a critical interpretation of a 1974 paper by Sir John Hicks. My use of Hicks’s work as a springboard also helps to explain why Hicks considered his book on capital theory to be “neo-Austrian” in character.1

HICKS, MATERIALISTS, AND FUNDISTS

Hicks grouped the numerous views on capital that have been expounded throughout the history of economic thought under two broad headings.2 By means of this classification Hicks called attention to the two basic ways economists conceptualize the notion of a stock of capital goods existing in the economy at a given moment in time. One is to see the stock as a collection of physical goods; by this approach aggregation into a stock provides us with a measure of the “volume of capital.” An important implication of this view is that “as between two economies which have capital stocks that are physically identical [the] Volume of Capital must be the same.”3 Those who share this view of the aggregate stock of capital, Hicks called “materialists.” The alternative view conceives of the aggregate stock of capital goods, not as a volume of physical capital, but as a “sum of values which may conveniently be described as a Fund”—something evidently quite different from the physical goods themselves—with the values derived from the expected future output flows. Those holding this view, Hicks called “fundists.”4

This fundist-materialist dichotomy is an elaboration (and partial revision) of a comment that Hicks made in the 1963 edition of his Theory of Wages.5 In that discussion Hicks identified “the two basic ways in which economists have regarded the capital stock of an economy” as involving, first, a “physical concept,” which treats capital “as consisting of actual capital goods,” and, second, a “fund concept,” which reduces capital to the “consumption goods that are foregone to get it.”6 These are the same two concepts Hicks identified in his 1974 paper, except that there he preferred an interpretation of the fund view in terms of future outputs rather than in terms of opportunity cost.

FUNDISTS: A TERMINOLOGICAL PUZZLE

Now Hicks’s use of the label fund to identify that notion of capital not viewed as physical goods is puzzling and could cause much confusion about the meaning of his discussion. Hicks declared that he “of course” borrowed the term fund from the history of economic thought; it is here that the confusion begins. The notion of capital as a fund is well known in the history of capital theory. It was carefully developed by John Bates Clark7 and repeatedly expounded by Frank H. Knight.8 Those who objected most vigorously to this view of capital were Eugen von Böhm-Bawerk in the first decade of the century and Friedrich A. Hayek in the fourth decade. Böhm-Bawerk declared that Clark’s concept of capital was mystical, and he insisted that to measure a stock of capital in value units in no way implies that what is being measured is an abstract quantity apart from the physical goods themselves.9 Hayek, in his debate with Knight, argued against the notion of capital as a fund of value, that is, a quantity apart from the particular goods making up the capital stock.10 Thus Hicks’s list of fundists must include Clark and Knight, and Böhm-Bawerk and Hayek must be on his list of materialists (certainly not on the list of fundists).

However, this was not the way Hicks classified these economists. J. B. Clark was “clearly” a materialist, and Hayek “of course, was a fundist.”11 Also, Böhm-Bawerk. “kept the fundist flag flying!”12 A basic familiarity with the history of capital theory leaves one puzzled, if not startled, by Hicks’s choice of terminology. Let us look more closely at how he employs his definitions.

HICKSIAN FUNDISM

To Hicks, the term fund apparently denotes a concept entirely different from that Clark and Knight had in mind when they used it. Knight’s capital-as-a-fund notion refers to a special way of viewing capital goods—as the temporary embodiment of a permanent store, or “fund,” of value. Hicks’s declaration that the Austrians are fundists has to do with their treatment of capital goods as essentially forward-looking components of multiperiod plans.13 The Clark-Knight view of capital as something other than the capital goods themselves is quite different from Hicks’s fundists’ view. Hicks himself—now a “neo-Austrian”—is on the side of his brand of fundists—the forward-looking kind. Without denying the propriety of a materialist, or backward-looking, perspective on capital, Hicks endorsed a “sophisticated” fundism in which the forward-looking character of capital goods is repeatedly emphasized. This made it easier for Hicks to recognize the importance of expectations in capital theory—a characteristically Austrian point of view.

Hicks apparently was inspired in his novel use of the term fund by Böhm-Bawerk’s notion of a subsistence fund.14 Despite my criticism of Hicks’s usage of the term fund, I must agree that Böhm-Bawerk did set a precedent for using it in this way. Moreover, by insisting that the notion of a subsistence fund is characteristic of Böhm-Bawerk’s approach, Hicks preserved what we must consider to be the essentially pure Austrian element in Böhm-Bawerk’s theory. Some effort has been made in recent work to ignore the forward-looking, multiperiod-planning aspect of Böhm-Bawerk’s theory. The productivity side of his system has been emphasized, and the time-preference aspect has been either suppressed altogether or treated as an inessential encumbrance.15 However, as Hicks recognized, the notion of a subsistence fund is an essential element of Böhm-Bawerk’s thinking about capital. This notion embodies the insight that, in choosing between processes of production of different durations, men appraise the prospective sacrifices these processes call for in terms of abstaining from more immediate consumption. Crucial to such appraisals is the size of the available capital stock, because it influences the prospective disutility associated with each of the alternatively required periods of waiting. Not only is this notion of a subsistence fund central to Böhm-Bawerk’s theory of capital, but it also is—in spite of his disconcerting concessions to the productivity-interest theorists16 —the essentially “Austrian” element in his thought. In the subsistence-fund concept is encapsulated Böhm-Bawerk’s concern for forward-looking, multiperiod human decision making; here the influence of subjective comparative evaluation of alternative future streams of income makes itself felt; and here there is room for a discussion of expectations and uncertainty. Hicks recognized all this when he identified the Austrians as fundists. Not only does the notion of the subsistence fund qualify Böhm-Bawerk as a Hicksian fundist, but it also, as Hicks implied, epitomizes what is “Austrian” in Böhm-Bawerk’s theory. I heartily agree with all this. At the same time, to emphasize the differences between the fund notion as used by Hicks and as usually associated with Clark and Knight, we may recall Hayek’s powerful criticisms of the subsistence-fund idea.17 Hayek’s extreme opposition to the Clark-Knight notion of a fund led him to point out some difficulties in Böhm-Bawerk’s original presentation of the subsistence-fund idea. While we can understand why Hicks labeled Böhm-Bawerk a fundist, we must still decide whether Hicks was correct in naming Hayek and modern-day Austrians fundists as well.

AUSTRIANS, MATERIALISTS, AND FUNDISTS

Where indeed does modern Austrianism stand in relation to the Hicksian materialist-fundist dichotomy? I contend that—whatever validity Hicks’s view of the Austrians has in terms of the older Austrian writers—Austrianism today does not at all fit this classification. Austrian economists occupy a position that is neither fundist nor materialist; they dismiss the basic question to which the fundists and materialists have traditionally addressed themselves as being unhelpful and completely irrevelant.

Austrians reject the fundist-materialist dichotomy because of their special understanding of the role individual plans play in the market process. A capital good is not merely a produced factor of production. Rather it is a good produced as part of a multiperiod plan in which it has been assigned a specific function in a projected process of production. A capital good is thus a physical good with an assigned productive purpose. To treat the stock of capital goods as a Hicksian materialist would is out of the question, for as Hicks recognized, this approach ignores the future streams of output that these capital goods are designed to help produce. But to treat the stock of capital goods as a Hicksian fundist might is also unacceptable, for it submerges the individualities of the various capital goods into a stock and replaces them with the sum of values supposed to represent the aggregate expected future value of the output imputed to these goods. To treat the stock of capital goods this way ignores the problem of the degree of consistency that prevails among the purposes assigned to each of the goods composing the capital stock. It also ignores questions of complementarity among goods, as well as the possibility that the productive purpose assigned by one producer to a particular capital good is unrealizable in the light of the plans of other producers or potential users of other capital goods. But all this is precisely what, to an Austrian economist, cannot be ignored.

In somewhat different terms, the Hicksian materialist-fundist classification is objectionable not so much for these alternative formulations as for the incompatibility of the task they attempt to carry out with the Austrian approach. That task is to arrive at a single value aggregate to represent the size of the stock of capital goods in an economy. It is this very attempt to collapse the multidimensional collection of capital goods into a single number that Austrian economists find unacceptable. If one wishes to talk about the total stock of all capital goods in an economy at a particular moment in time, one must not overlook the roles assigned to the various goods by individuals; in other words, one must treat the stock as consisting at all times of essentially heterogeneous items that defy aggregation. They defy aggregation not only because of physical heterogeneity but also, more important, because of the diversity of the purposes to which these goods have been assigned. Mises emphatically dismissed the very notion of an aggregate of physical capital goods as empty and useless. The “totality of the produced factors of production,” Mises wrote, “is merely an enumeration of physical quantities of thousands and thousands of various goods. Such an inventory is of no use to acting. It is a description of a part of the universe in terms of technology and topography and has no reference whatever to the problems raised by the endeavors to improve human well-being.”18

ON MEASURING CAPITAL: THE INDIVIDUAL

Other economists as well as the Austrians see the serious theoretical difficulties that face all attempts to measure real capital. It seems useful to review briefly where these difficulties lie, both in the attempt to measure a single individual’s stock of capital goods and the attempt to measure society’s stock of capital goods.19

Consider a list of all the physical items that make up a single individual’s stock of capital goods. Their physical heterogeneity prohibits “adding them up”—there is no natural unit of measurement. Instead one may try to devise an index number that will permit the heterogeneous items to be treated as one dimensional. But if the measure thus obtained is to be interpreted as representing the quantity of physical goods in the stock, the attempt hardly seems worthwhile. Not only is the advantage in replacing a list by a number unclear, but such a replacement obviously hides an important aspect of economic reality. A man’s future plans depend not only on the aggregate size of his capital stock but also very crucially upon the particular properties of the various goods making up the stock. Goods that can be used in a complementary relationship permit certain plans that a purely physical measure necessarily suppresses.

Instead of seeking to measure the quantity of physical goods as physical goods, one may seek to measure one’s capital stock in terms of the amount of past sacrifice undertaken to achieve the present stock. This would be a backward-looking measure. For such a measure, the heterogeneity of the goods making up the capital stock would present no difficulty. While one may question the usefulness of measuring past sacrifice, it is at least a task that does not lack meaning. On the other hand, measuring the size of the capital stock in terms of past sacrifice raises heterogeneity problems of a different kind. Past sacrifices are unlikely to have been homogeneous in character. And even if market values, say, are employed to express past sacrifices, there remains a very special “heterogeneity” difficulty arising from the circumstance that past sacrifices were undertaken at different dates in the past. These difficulties must necessarily render the search for a backward-looking measure unsuccessful.

A far more popular alternative is to measure the size of stocks of capital goods in terms of expected contribution to future streams of output. Attempts to arrive at so-called forward-looking measures of capital are, of course, the essence of Hicksian fundism. It is misleading to talk of a particular resource as being unambiguously associated with a definite stream of forthcoming output, in the sense that such an output stream flows automatically from the resource itself. Decisions must be made as to how a resource is to be deployed before one can talk of its future contribution to output. Because there are alternative uses for a resource and alternative clusters of complementary inputs with which a resource may be used, it is confusing to see a resource as representing a definite future output flow before the necessary decisions on its behalf have been made.

Nonetheless, recognizing all these difficulties, it cannot be denied, in the last analysis, that forward-looking measures of the size of capital stocks are being made all the time. Individuals do measure the potential contributions of particular capital goods to future output. They do so whenever these goods are bought and sold, and whenever owners of such goods refrain from selling them at going market prices. What cannot be “objectively” measured by the outsider turns out to be evaluated subjectively by the relevant decision maker.

MEASURING CAPITAL: THE ECONOMY

The difficulties involved in measuring the size of an individual’s stock of capital goods become exaggerated when it is the size of an entire nations’s stock of capital goods that one is measuring. The theoretical difficulties involved in aggregating physical items present formidable obstacles to thoroughgoing, “aggregative,” Hicksian materialism. As Hicks correctly pointed out, Austrian economists have little sympathy with such an approach. But measuring the size of the capital stock in economic rather than in physical terms is hardly more promising. We may dismiss backward-looking measures as having failed, even at the individual level. Forward-looking measures of an individual’s capital stock are impossible to achieve in an objective way but are being made all the time in the private dealings of individual agents. In considering forward-looking measures of a nation’s stock of capital goods—that is, Hicks’s fundism in the 1973 version—the possibility of subjective evaluation loses virtually all meaning (except in a sense to be discussed in the subsequent section); the problems that prevent objective measurement at the level of the individual are intensely reinforced by additional problems. One difficulty is relating a given item (in the inventory of the social stock of capital goods) to its prospective output before the preliminary decisions, necessary for the identification of that output, have been made; another is that the prospective output associated with a capital good owned by Jones may be inconsistent with a capital good owned by Smith. A forward-looking measure of Jones’s capital stock and also of Smith’s must presume plans on the part of Jones and of Smith, but Jones’s plan and Smith’s plan may be, in whole or in part, mutually exclusive. Perhaps Jones expects rain and builds a factory to produce umbrellas, whereas Smith expects fine weather and builds a factory to produce tennis racquets. That one of the two has overestimated the possible output of his factory (and thus will, in the future, be seen to have incorrectly measured the size of his capital stock) is not significant. What is significant is that it is already now meaningless to add a valuation of Jones’s factory to a valuation of Smith’s factory when each valuation depends on the expectation of one that the expectation of the other will prove erroneous. We are, therefore, forced as Austrian economists to decline Hicks’s invitation to join the fundist club. To view the aggregate capital stock as a fund requires us in the end to give up our concern with individual plans upon which forward-looking measures ultimately depend for their very meaning! By refusing to surrender our Austrian interest in individual plans, however, we face another difficulty.

ON THE NOTION OF THE QUANTITY OF CAPITAL PER HEAD

We have seen that attempts to measure the quantity of capital goods in an economy must fail on theoretical grounds. Yet it is virtually impossible to avoid making statements in which such measurement is implied. In the writing of Mises, for example, we find frequent reference to the consequences of the fact that one country possesses a greater quantity of capital (or a greater quantity of capital per worker) than a second country.20 Such statements imply the possibility that aggregate capital measurement has a rough meaningfulness. Yet how do we reconcile our theoretical rejection of aggregative capital measurement with a willingness to make statements of this kind?

The answer to this difficulty lies in the possibility, mentioned above, of subjective evaluation by an individual of the aggregate worth of his own stock of capital goods. Individual forward-looking measurement is both possible and feasible, because the problem of possibly inconsistent plans does not arise. An individual evaluates each component of his capital stock in terms of the plans he has in mind; he may have to take care to avoid possible inconsistencies, but in appraising his measurement of his capital we may assume that he has successfully integrated his own plans. What cannot, except in the state of general equilibrium, be assumed for an economy as a whole is assumed as a matter of course for the individual.

Underlying statements that compare the quantity of capital in one country with that in another is a convenient and relatively harmless fiction. One imagines that one has complete control over all the items in a nation’s capital stock—that one is, in effect, the economic czar of a socialist economy. One is then in exactly the same position in relation to the nation’s stock of capital as an individual is in relation to his own stock. By the use of this fiction, problems of inconsistent plans have been simply imagined away.

In sidestepping in this way the theoretical difficulties that frustrate attempts to arrive at aggregate measures of capital, we have, it may be argued, endorsed Hicksian fundism after all. But this is by no means the case. In the context of a market economy the fiction that all inconsistencies among plans may be ignored is, for most purposes, highly hazardous and misleading. Although there are instances in which needed reference to the aggregate quantity of capital can be supported in the way described, to use this fiction to construct a general treatment of aggregated capital is entirely unacceptable to Austrian economists. It is the market process that has the property of discovering inconsistencies among plans and of offering incentives for their elimination. To introduce capital into the analysis of the market process in a way that assumes that plan inconsistencies do not exist is to espouse decidedly non-Austrian assumptions and to become enmeshed in those insoluble contradictions characterizing orthodox microeconomic theory, the escape from which provides the strongest case for a return (or an advance) to the Austrian position.

NOTES

On Austrian Capital Theory

Ludwig M. Lachmann

To most economists today the words Austrian capital theory denote work in the line of succession of Eugen von Böhm-Bawerk. Sir John Hicks noted that the tradition originated before the last quarter of the nineteenth century and can even be traced to the Renaissance, yet described his book Capital and Time as A Neo-Austrian Theory inasmuch as it deals with production processes that take time to complete.1 How many know that Carl Menger regarded Böhm-Bawerk’s theory as “one of the greatest errors ever committed”?2

I wish to argue, however, that Böhm-Bawerk’s model, being essentially macroeconomic, does not provide an adequate basis for a capital theory that could properly be called Austrian. Work in constructing such a theory must start at the foundation, and this means at the level of individual action. Böhm-Bawerk never meant to be a capital theorist. He was essentially a Ricardian who asked a Ricardian question: “Why are the owners of impermanent resources able to enjoy a permanent income and what determines its magnitude?” The notion of a temporal capital structure consisting of a sequence of stages of production was a mere by-product of an inquiry into the causes and the magnitude of the rate of return on capital and not the main subject. In pursuit of this Ricardian inquiry Böhm-Bawerk battled on and failed like a Ricardian. In his model there are one factor of production, labor, and one final consumption good. Ricardo failed when trying to apply conclusions holding in a simple corn economy to a multicommodity world, in which the real wage rate depends on the workers’ expenditure pattern and relative prices of wage goods (hence on choice!). Böhm-Bawerk’s argument foundered on the same rock.

With a number of consumption goods, we need a price system which must be invariant to changes in the rate of interest that accompany the accumulation of capital. But such a price system cannot exist. Moreover, with the subsistence fund consisting of a number of goods, some of the capital invested will be malinvested if the composition of the fund does not correspond to the workers’ expenditure pattern. In the absence of perfect foresight on the part of the capital owners, some malinvestment is inevitable, and some of the capital accumulated vanishes from the scene.

There are other reasons for abandoning Böhm-Bawerk’s theory. As Samuelson pointed out3 and Hicks noted,4 the possibility of “reswitching” affects the “average length of the period of production” just as much as the “quantity of capital.” Moreover, to reduce the whole complex of relationships among capital resources—within firms as well as between firms in different industries and stages of processing, often with relations of complementarity in time but just as often not—to the single dimension of time is a bold idea (originating with Ricardo), but not a very good one. From an Austrian point of view, too much violence is done to the diversity of the world.

I suggest that we reverse the Ricardian approach to the problem of capital and make the capital structure the primary object of study by starting at the ground level, that is, at the microlevel where production plans are made and carried out.

On the other hand, can the rate of return on capital, Ricardo’s and Böhm-Bawerk’s primary object, have any place in a market economy if, in an Austrian mood, the variety of goods and services and its corollary, the heterogeneity of capital, are recognized? This rate of return is of central concern to the neoclassical theorists, from Irving Fisher to Robert Solow, and constitutes the main issue of controversy. For the neoclassical economist it is a dependant variable of the general-equilibrium system. To the contrary, the neo-Ricardians hold that it has to be determined outside this system since there can be no quantity of capital and hence no marginal product of it. In my view this controversy about a fictitious macroeconomic magnitude is a symptom of the arid macroeconomic formalism that afflicts both schools. For in a market economy a uniform rate of return on all capital invested does not exist.

If we follow Menger instead of Böhm-Bawerk, a distinction may be made between the rate of interest on loans and the rate of profit on capital invested. The former does exist, that is, there is a structure of interest rates determined daily in the loan market as its equilibrium price. The latter does not.5 There is also in a market economy a uniform rate of (dividend and earnings) yield on capital assets that the market assigns to the same class. But this uniform rate of yield has nothing to do with either Ricardo’s rate of profits or Fisher’s rate of return over cost. It reflects all capital gains and losses made since the inception of the company in question. It is precisely the diversity of such gains and losses recorded on the stock of different companies that permits the market to make the present rate of yield on all assets uniform. This Mengerian criticism of Böhm-Bawerk is confirmed by Hicks, the leading neoclassical thinker, who, having proclaimed the “’Austrian’ affiliation of my ideas” and paid a tribute to Böhm-Bawerk,6 nevertheless concluded on the last page of his book that “only in the steady state can we unambiguously determine the size of profits. Out of the steady state the profit that is allocated to a particular period depends on expectations . . . there is no such convention that is unambiguously right.”7 But the “steady state,” like all equilibria, is a fiction, and the real Austrian view has been Hicks’s final view all the time!

Our main task is to lay the foundation for a theory of the capital structure. Our capital theory, unlike Böhm-Bawerk’s, is not devised to serve as a basis for an interest theory. Its purpose is to make the shape, order, and coherence of the capital structure intelligible in terms of human action.

Starting with the facts of the heterogeneity of capital and following its logic, we find in every firm a capital combination—a combination of land, buildings, equipment, machines, and stocks of various goods. There are constraints on the possible modes of complementarity of these resources, some of them technological, some the results of the market situation. Relevant here are both the market for the products of the firm and those for labor and materials. Within these boundaries the manager-entrepreneur chooses a mode for the use of the capital under his control to maximize his profits. And since his decision involves the future as well as the present, he bases his plan on his expectations.

Since his capital combination could produce a number of different output streams of various composition, he has to choose among them. But his capital combination is not immutable; he can reshuffle it, discarding some capital goods and buying others. Entrepreneurial action with regard to capital, then, requires continuous “alertness” to change and a willingness to make frequent changes, the switching “on” or “off” of various output streams as well as the reshuffling of capital combinations. The firm and its resources are immersed in the stream of knowledge. Technical progress in the form of “learning by doing” probably takes place within the firm’s walls. But new knowledge usually reaches it by way of the markets for its products, factor services and alternative capital goods that might be added to, or used as substitutes in, the existing capital combinations.

A comparison may be made between the just described heterogeneity of capital and that in other models. Neoclassical writers like Samuelson and Solow apparently admit the heterogeneity of capital as a matter of fact and in principle, but eschew the consequences, whenever a problem germane to it arises, by means of such devices as the surrogate production function or the assumption of a one-commodity world. Neo-Ricardian criticism emphasizes the need for a price system invariant to interest changes but can carry the matter no farther since the dynamics of the market process is beyond its reach.

In commodity markets prices are fixed directly and incomes indirectly. Each firm with its capital combination is always in disequilibrium and by its action in this state contributes to the continuous reshaping of the capital structure.

The individuality of each firm rests on the varying interpretations it places on the ceaseless stream of knowledge, different segments in the minds of different manager-entrepreneurs finding expression in the specific composition of their capital combinations. In time, output streams are switched on and off, and the composition of capital combinations is modified. New investment is but a by-product of the regrouping of existing capital resources. Hence the futility of all attempts to “measure” capital.

In dealing with the capital structure of society and its complex relationships with the capital combinations of the firms, we should be aware of the prototypical relationship it reflects between an aggregate and its particles, between the macrostructure and its microelements. If we criticize the inadequacy of macromodels, we should be able to show that we can do better. We must be able to deal with them without losing sight of their microbasis.

The capital structure of society is an aggregate of capital combinations, but only in a state of general equilibrium can the capital goods belonging to different firms be regarded as additive, when they stand to each other in a relationship of complementarity. It is, however, a type of complementarity different from that governing capital goods within the same capital combination. We have to distinguish between the planned complementarity of the latter, the result of entrepreneurial choice and decision, and the unplanned complementarity of capital resources at various stages of production, which is an outcome of the operation of the market process.

The capital structure of society is never completely integrated. The competitive nature of the market process entails incoherence of plans and limits the coherence of the resulting order. A tendency toward the integration of the structure does exist. Capital goods that do not fit into any existing combination are useless to their owners, are “not really capital,” and will soon be scrapped. “Holes” in the existing complementarity pattern, on the other hand, must cause price-cost differences and thus call for their elimination. But expectations of early change in the present situation may impede the process of adjustment, and even when this does not happen, the forces of adjustment themselves may be overtaken by other forces.

One result of the recent discussion on “reswitching” is to the advantage of the Austrian school. As long as all capital is regarded as homogeneous, managers may respond to a marginal fall in the rate of interest by a marginal act of substitution of capital for labor. But heterogeneity of capital entails a regrouping of the existing capital combination; some capital goods may have to be discarded, others acquired. It is no longer a marginal adjustment that is called for but entrepreneurial choice and decision. As Pasinetti pointed out, “Two techniques may well be as near as one likes on the scale of variation of the rate of profit and yet the physical capital goods they require may be completely different.”8

In a world of disequilibrium, entrepreneurs continually have to regroup their capital combinations in response to changes of all kinds, present and expected, on the cost side as well as on the market side. A change in the mode of income distribution is merely one special case of a very large class of cases to which the entrepreneur has to give constant attention. No matter whether switching or reswitching is to be undertaken, or any other response to market change, expectations play a part, and the individuality of each firm finds its expression in its own way. Yet only “reswitching” has of late attracted the interest of theoreticians. There is more in the world of capital and markets than is dreamt of in their philosophy.

NOTES

Toward a Critique of Macroeconomics

Ludwig M. Lachmann

In reconstructing Austrian economics, I have recommended the concept of market process as the foundation of all economic life (see my paper “On the Central Concept,” included in this volume). In other words, we must start at the microlevel. How, then, shall we deal with such aggregates as income, consumption, and wages, which, according to the same terminology, must be regarded as macroeconomic magnitudes?

In my paper “On Austrian Capital Theory” (also included in this volume) I said that we may regard the relationship between the capital structure of society and its capital combinations as the prototype of the relationship between a macroeconomic magnitude and its microelements. In other words, the former must never be brought into an argument without giving a careful account of the latter; for changes in the constellation of the microelements will affect the macromagnitude itself.

However, in modern macroeconomic literature, whether neoclassical or neo-Ricardian, there is little awareness of this fundamental postulate. From the moment of inception, the macroeconomic aggregates in these writings seem to lead a life of their own, to be endowed with qualities sufficient to allow their adjustment to change in their environment, but change within them is ignored.

Among the macroeconomic aggregates, we have to distinguish between stocks and flows. While it is generally agreed that the former cannot in a world of uncertainty be measured, the reasons given are not satisfactory. Why, then, cannot capital be measured?

In stationary equilibrium capital can be measured; for here, but only here, the discounted present value of the highest income stream obtainable from a given capital resource must be exactly equal to its cost of reproduction if the same interest rate is used for both calculations. Otherwise there would be investment or disinvestment, neither of which is compatible with a stationary state.

Outside the equilibrium of the stationary state, replacement cost and present value of a discounted future income stream will diverge. If we regard the latter as the economically significant value—and few economists doubt that (bygones are bygones)—we still have no yardstick by which to measure the assets of different firms. The neo-Ricardians stress the role of the interest rate as a discount factor; every time it changes, so does capital value. True as this may be, the real reason for our inability to measure capital lies in the subjective nature of expectations concerning future income streams. If we tried to measure capital by asking each owner for his valuation of his capital stock (for example, fire insurance value), we would get a set of consistent answers, but every change in ownership would invalidate at least one answer. Such an attempt to extract measurable objective value from subjective valuation must fail. This does not mean, however, that in a more limited context and for more limited purposes similar attempts may not be more sucessful.

The second part of the argument is that, while stocks cannot be measured, flows can. All of modern macroeconomics—the theories about investment, income, exports, and wages, as well as the social accounting systems that are widely regarded as one of its triumphs—rests on the assumption that output and income streams can be measured. Can they? As we shall see, the main support for this assumption is superficial as well as highly misleading.

Here we have one of the most intricate problems of measurement we encounter in a multicommodity world. In a classical corn economy all stocks and flows have their physical measures, but in a multicommodity world gallons of brandy and of whiskey, surgical instruments and musical instruments cannot be added up. Like David Ricardo and Eugen von Böhm-Bawerk, we need a price system invariant to the very effects of the variations of the variables we wish to measure. Can such a system exist?

The market prices on which national income measurement is ostensibly based are presumably equilibrium prices. But what kind of equilibrium prices are they? Is consistent aggregation, which macroeconomic thought requires to make sense, possible on the basis of prices that may not be consistent? Walrasian-Paretian long-run equilibrium does provide a consistent price system, but the market prices at which output flows are evaluated in the national income statistics are no such long-run equilibrium prices. They are market-day-equilibrium prices at best. There is no reason why they should be consistent with each other. The whole argument for using average market prices over a year as a basis for the valuation of output flows appears to rest on a confusion between long-run, short-run, and market-day equilibrium. Only prices belonging to the first category are elements of a coherent price system and might be used for the purpose of consistent aggregation. All the others are not. An average of market-day-equilibrium prices over a long period is not the same thing as a Walrasian long-run equilibrium price. Yet the computation of the macroeconomic aggregates that are released daily by the media and are so prominent in the products of the textbook industry rests on such elementary confusion.

Even if such a coherent long-run equilibrium price system did exist and could be known, it would not last. Its data would not remain the same for long. The steady flow of knowledge will tomorrow produce a pattern of knowledge different from today’s, and apparent changes in demand and supply will entail a new set of equilibrium prices. Not without reason are we compelled to look for a paradigm to replace the general-equilibrium model.

In a market economy, on the other hand, we have in the stock exchange a center for the consistent daily evaluation of all the more important capital combinations. This, to be sure, is not objective measurement. The measurement of capital is forever beyond our reach. But it is something more than mere subjective evaluation. Stock exchange prices of capital assets reflect a balance of expectations. There are two classes of traders in the market, and in an asset market the fundamentum divisionis is the optimism or pessimism of expectations. Hence, market prices of securities (and the capital assets they represent) have social significance, we might say a “social objectivity,” which transcends the mere subjective expectations of buyers and sellers on which they are based. The objects of valuation are not individual capital goods but fractions of capital combinations that are the substrate of multiperiod plans. It is expectations about the success of multiperiod plans that bulls and bears are continuously expressing.

Stock exchange equilibrium is market-day equilibrium. Tomorrow’s set of equilibrium prices will be different from today’s. But as we are dealing with an exchange economy, not a production economy, the fact of change does not impair the consistency and significance of market valuation. Free access to all parts of the market, together with the speed at which brokers carry out their clients’ instructions, makes it possible to be at once a buyer of one kind of security and a seller of another. Arbitrage does the rest to produce a valuation of all company-owned assets that is consistent in that it reflects a balance of expectations between bulls and bears. The fact that tomorrow’s balance will be different from today’s faithfully reflects the flow of knowledge.

The difference between the commodity market and the securities market is instructive. Today’s potato price may not be consistent with today’s prices for other vegetables. If so, equilibrating forces that require time will come into operation. But today’s market equilibrium price may also be inconsistent with the long-run supply and demand for potatoes. The equilibrating forces released by the second disparity may impede or reinforce those released by the first. Certainly they require a different time dimension to be fully deployed. And the longer the time required by any force, the greater the probability that it will be affected by unexpected change. To opt for the market process against general equilibrium means to accept the implication that a fully coherent price system providing a basis for consistent aggregation can never exist.

We find here another reason why steady growth—uniform motion of that supermacroaggregate, the economic system—has to be regarded as absurd. Equilibrating forces in different markets, even if none is affected by unexpected change, require different time periods to do their work. This is obvious if we contrast agricultural produce markets with those for industrial goods. Steady growth, however, requires all equilibrating forces to operate within the same time period.

But the main argument against steady growth is a necessary consequence of the divergence of expectations. Equilibrium in a production economy requires an equilibrium composition of the capital stock.1 With at least some capital goods durable and specific, can we conceive of such a state? A growing economy is a changing economy. It exists in an uncertain world in which men have to formulate expectations on which to base their plans. Different men will characteristically have different expectations about the same future event, and they cannot all be right. Some expectations will be disappointed, and the plans based upon them will have to be revised. The capital invested will turn out to have been malinvested. But the existence of malinvested capital is incompatible with the equilibrium composition of the capital stock. Hence steady growth is impossible. “Macroequilibrium in motion” is not an acceptable paradigm and has to be replaced by the market process.

As has been noted, the stock exchange, a fundamental institution of the market economy, imparts an element of social objectivity to individual stock valuations. This is by no means its only, or even its only significant, function. It facilitates the take-over bid by means of which capital resources get into the hands of those who can promise their owners a higher return. Without a stock exchange such bids would of course still be possible. shareholders could be notified that, if their capital resources were used in a different way (by producing a different output stream), better results could be obtained. But in the absence of market prices shareholders would be without a yardstick to measure the advantage offered them. For the optimal use of existing resources in a socialist economy, an elaborate bureaucratic organization would be needed to shift resources from points of lower to points of higher usefulness.

Perhaps the most important economic function of the stock exchange is the redistribution of wealth by means of the capital gains and losses it engenders in accordance with the market view about the probable success or failure of present multiperiod plans. In certain neoclassical writings the present distribution of resources is a datum of the set of equilibrium prices and quantities at each point of time. Over time, however, the mode of distribution of wealth changes as reflected in capital gains and losses. In fact, the present mode of distribution of wealth is nothing less than the cumulative result of the capital gains and losses of the past. Devotees of a redistribution of wealth in the name of social justice should be aware that, even if the state by the use of coercion were able to produce a supposedly socially desirable mode of distribution today, the market, if permitted to exist, via capital gains and losses would produce a different mode tomorrow.

I have tried to show that—in contrast to an opinion apparently widely held—flows in a multicommodity world are all too often inconsistent aggregates, whereas stocks, while unmeasurable in an uncertain world, may in favorable circumstances be subjected to consistent evaluation. The former is particularly true of the Keynesian I=S, current investment, the “net addition to the capital stock.” If the stock is unmeasurable, how can we tell what is an addition to it? Gross investment is in principle measurable and would be in practice if we had a consistent price system for capital goods. But to divide this flow into net investment and replacement, we need an objective criterion.

Individual decisions by capital owners on such division may be consistent in the sense that the decisions of individual owners do not conflict, but not in the sense that the word measurement implies, that is, that different individuals measuring the same object get identical results. Each owner’s judgment of his investment expenditure for maintenance and replacement of his existing wealth on the one hand and for a “net addition” on the other rests on a subjective expectation about the future, as nobody explained more forcefully than Keynes in his unjustly neglected “Appendix on User Cost.”2 It follows that a macroeconomic magnitude investment as an objectively measurable, that is, consistently ascertainable, entity does not exist. What does exist is an aggregate of subjective valuations dependent on owners’ expectations and the distribution of ownership. An important part of what appears as investment in the official reports of government and business rests on subjective estimates of those who compile the statistics or of those who release the returns.

This imperfection in macroeconomics, like many others in an imperfect world, could be regarded as inherent in any application of abstract theory to a concrete situation. This defense, however, is not valid. We have to distinguish between defects due to the unsatisfactory nature of our material, that is, the state of our statistical sources, and defects due to muddled thinking. A cure for the former is no cure for the latter. Piero Sraffa on a famous occasion made this point with vigor and clarity. His position has been summarized as follows:

Mr. Sraffa thought one should emphasize the distinction between two types of measurement. First, there was the one in which the statisticians were mainly interested. Second, there was measurement in theory. The statisticians’ measures were only approximate and provided a suitable field for work in solving index number problems. The theoretical measures required absolute precision. Any imperfections in these theoretical measures were not merely upsetting, but knocked down the whole theoretical basis . . . . Mr. Sraffa took the view that if one could not get the measures required by the theorists’ definitions, this was a criticism of theory, which the theorists could not escape by saying that they hoped their theories would not often fail. If a theory failed to explain a situation, it was unsatisfactory.3

NOTES

The Austrian Theory of Money

Murray N. Rothbard

The Austrian theory of money virtually begins and ends with Ludwig von Mises’s monumental Theory of Money and Credit, published in 1912.1 Mises’s fundamental accomplishment was to take the theory of marginal utility, built up by Austrian economists and other marginalists as the explanation for consumer demand and market price, and apply it to the demand for and the value, or the price, of money. No longer did the theory of money need to be separated from the general economic theory of individual action and utility, of supply, demand, and price; no longer did monetary theory have to suffer isolation in a context of “velocities of circulation,” “price levels,” and “equations of exchange.”

In applying the analysis of supply and demand to money, Mises used the Wicksteedian concept: supply is the total stock of a commodity at any given time; and demand is the total market demand to gain and hold cash balances, built up out of the marginal-utility rankings of units of money on the value scales of individuals on the market. The Wicksteedian concept is particularly appropriate to money for several reasons: first, because the supply of money is either extremely durable in relation to current production, as under the gold standard, or is determined exogenously to the market by government authority; and, second and most important, because money, uniquely among commodities desired and demanded on the market, is acquired not to be consumed, but to be held for later exchange. Demandto-hold thereby becomes the appropriate concept for analyzing the uniquely broad monetary function of being held as stock for later sale. Mises was also able to explain the demand for cash balances as the resultant of marginal utilities on value scales that are strictly ordinal for each individual. In the course of his analysis Mises built on the insight of his fellow Austrian Franz Cuhel to develop a marginal utility that was strictly ordinal, lexicographic, and purged of all traces of the error of assuming the measurability of utilities.

The relative utilities of money units as against other goods determine each person’s demand for cash balances, that is, how much of his income or wealth he will keep in cash balance as against how much he will spend. Applying the law of diminishing (ordinal) marginal utility to money and bearing in mind that money’s “use” is to be held for future exchange, Mises arrived implicitly at a falling demand curve for money in relation to the purchasing power of the currency unit. The purchasing power of the money unit, which Mises also termed the “objective exchange-value” of money, was then determined, as in the usual supply-and-demand analysis, by the intersection of the money stock and the demand for cash balance schedule. We can see this visually by putting the purchasing power of the money unit on the y-axis and the quantity of money on the x-axis of the conventional two-dimensional diagram corresponding to the price of any good and its quantity. Mises wrapped up the analysis by pointing out that the total supply of money at any given time is no more or less than the sum of the individual cash balances at that time. No money in a society remains unowned by someone and is therefore outside some individual’s cash balance.

While, for purposes of convenience, Mises’s analysis may be expressed in the usual supply-and-demand diagram with the purchasing power of the money unit serving as the price of money, relying solely on such a simplified diagram falsifies the theory. For, as Mises pointed out in a brilliant analysis whose lessons have still not been absorbed in the mainstream of economic theory, the purchasing power of the money unit is not simply the inverse of the so-called price level of goods and services. In describing the advantages of money as a general medium of exchange and how such a general medium arose on the market, Mises pointed out that the currency unit serves as unit of account and as a common denominator of all other prices, but that the money commodity itself is still in a state of barter with all other goods and services. Thus, in the premoney state of barter, there is no unitary “price of eggs”; a unit of eggs (say, one dozen) will have many different “prices”: the “butter” price in terms of pounds of butter, the “hat” price in terms of hats, the “horse” price in terms of horses, and so on. Every good and service will have an almost infinite array of prices in terms of every other good and service. After one commodity, say gold, is chosen to be the medium for all exchanges, every other good except gold will enjoy a unitary price, so that we know that the price of eggs is one dollar a dozen; the price of a hat is ten dollars, and so on. But while every good and service except gold now has a single price in terms of money, money itself has a virtually infinite array of individual prices in terms of every other good and service. To put it another way, the price of any good is the same thing as its purchasing power in terms of other goods and services. Under barter, if the price of a dozen eggs is two pounds of butter, the purchasing power of a dozen eggs is, inter alia, two pounds of butter. The purchasing power of a dozen eggs will also be one-tenth of a hat, and so on. Conversely, the purchasing power of butter is its price in terms of eggs; in this case the purchasing power of a pound of butter is a half dozen eggs. After the arrival of money, the purchasing power of a dozen eggs is the same as its money price, in our example, one dollar. The purchasing power of a pound of butter will be fifty cents, of a hat ten dollars, and so forth.

What, then, is the purchasing power, or the price, of a dollar? It will be a vast array of all the goods and services that can be purchased for a dollar, that is, of all the goods and services in the economy. In our example, we would say that the purchasing power of a dollar equals one dozen eggs, or two pounds of butter, or one-tenth of a hat, and so on, for the entire economy. In short, the price, or purchasing power, of the money unit will be an array of the quantities of alternative goods and services that can be purchased for a dollar. Since the array is heterogeneous and specific, it cannot be summed up in some unitary price-level figure.

The fallacy of the price-level concept is further shown by Mises’s analysis of precisely how prices rise (that is, the purchasing power of money falls) in response to an increase in the quantity of money (assuming, of course, that the individual demand schedules for cash balances or, more generally, individual value scales remain constant). In contrast to the hermetic neoclassical separation of money and price levels from the relative prices of individual goods and services, Mises showed that an increased supply of money impinges differently upon different spheres of the market and thereby ineluctably changes relative prices.

Suppose, for example, that the supply of money increases by 20 percent. The result will not be, as neoclassical economics assumes, a simple across-the-board increase of 20 percent in all prices. Let us assume the most favorable case—what we might call the Angel Gabriel model, that the Angel Gabriel descends and overnight increases everyone’s cash balance by precisely 20 percent. Now all prices will not simply rise by 20 percent; for each individual has a different value scale, a different ordinal ranking of utilities, including the relative marginal utilities of dollars and of all the other goods on his value scale. As each person’s stock of dollars increases, his purchases of goods and services will change in accordance with their new position on his value scale in relation to dollars. The structure of demand will therefore change, as will relative prices and relative incomes in production. The composition of the array constituting the purchasing power of the dollar will change.

If relative demands and prices change in the Angel Gabriel model, they will change much more in the course of real-world increases in the supply of money. For, as Mises showed, in the real world an inflation of money is alluring to the inflators precisely because the injection of new money does not follow the Angel Gabriel model. Instead, the government or the banks create new money to be spent on specific goods and services. The demand for these goods thereby rises, raising these specific prices. Gradually, the new money ripples through the economy, raising demand and prices as it goes. Income and wealth are redistributed to those who receive the new money early in the process, at the expense of those who receive the new money late in the day and of those on fixed incomes who receive no new money at all. Two types of shifts in relative prices occur as the result of this increase in money: (1) the redistribution from late receivers to early receivers that occurs during the inflation process and (2) the permanent shifts in wealth and income that continue even after the effects of the increase in the money supply have worked themselves out. For the new equilibrium will reflect a changed pattern of wealth, income, and demand resulting from the changes during the intervening inflationary process. For example, the fixed income groups permanently lose in relative wealth and income.2

If the concept of a unitary price level is a fallacious one, still more fallacious is any attempt to measure changes in that level. To use our previous example, suppose that at one point in time the dollar can buy one dozen eggs, or one-tenth of a hat, or two pounds of butter. If, for the sake of simplicity, we restrict the available goods and services to just these three, we are describing the purchasing power of the dollar at that time. But suppose that, at the next point in time, perhaps because of an increase in the supply of dollars, prices rise, so that butter costs one dollar a pound, a hat twelve dollars, and eggs three dollars a dozen. Prices rise but not uniformly, and all that we can now say quantitatively about the purchasing power of the dollar is that it is four eggs, or one-twelfth of a hat, or one pound of butter. It is impermissible to try to group the changes in the purchasing power of the dollar into a single average index number. Any such index conjures up some sort of totality of goods whose relative prices remain unchanged, so that a general averaging can arrive at a measure of changes in the purchasing power of money itself. But we have seen that relative prices cannot remain unchanged, much less the valuations that individuals place upon these goods and services.3

Just as the price of any good tends to be uniform, so the price, or purchasing power of money as Mises demonstrated, will tend to be uniform throughout its trading area. The purchasing power of the dollar will tend to be uniform throughout the United States. Similarly, in the era of the gold standard, the purchasing power of a unit of gold tended to be uniform throughout those areas where gold was in use. Critics who point to persistent tendencies for differences in the price of money between one location and another fail to understand the Austrian concept of what a good or a service actually is. A good is not defined by its technological properties but by its homogeneity in relation to the demands and wishes of the consumers. It is easy to explain, for example, why the price of wheat in Kansas will not be the same as the price of wheat in New York. From the point of view of the consumer in New York, the wheat, while technologically identical in the two places, is in reality two different commodities: one being “wheat in Kansas” and the other “wheat in New York.” Wheat in New York, being closer to his use, is a more valuable commodity than wheat in Kansas and will have a higher price on the market. Similarly, the fact that a technologically similar apartment will not have the same rental price in New York City as in rural Ohio does not mean that the price of the same apartment commodity differs persistently; for the apartment in New York enjoys a more valuable and more desirable location and hence will be more highly priced on the market. The “apartment in New York” is a different and more valuable good than the “apartment in rural Ohio,” since the respective locations are part and parcel of the good itself. At all times, a homogeneous good must be defined in terms of its usefulness to the consumer rather than by its technological properties.

To extend the analysis, the fact that the cost of living may be persistently higher in New York than in rural Ohio does not negate the tendency for a uniform purchasing power of the dollar throughout the country. For the two locations constitute a different set of goods and services, New York providing a vastly wider range of goods and services to the consumer. The higher costs of living in New York are the reflection of the greater locational advantages, of the more abundant range of goods and services available.4

In his valuable history of the theory of international prices, C. Y. Wu emphasized the Mises contribution and pointed out that Mises’s explanation was in the tradition of Ricardo and Nassau Senior, who “was the first economist to give a clear explanation of the meaning of the classical doctrine that the value of money was everywhere the same and to demonstrate that differences in the prices of goods of similar composition in different places were perfectly reconcilable with the assumption of an equality of the value of money.”5 Pointing out that Mises arrived at this concept independently of Senior, Wu then developed Mises’s application to the alleged locational differences in the cost of living. As Wu stated, “To him [Mises] those who believe in national differences in the value of money have left out of account the positional factor in the nature of economic goods; otherwise they should have understood that the alleged differences are explicable by differences in the quality of the commodities offered and demanded.” Wu concluded with a quote from Mises’s Theory of Money and Credit: “The exchange-ratio between commodities and money is everywhere the same. But men and their wants are not everywhere the same, and neither are commodities.”6

If the tendency of the purchasing power of money is to be everywhere the same, what happens if one or more moneys coexist in the world? By way of explanation, Mises developed the Ricardian analysis into what was to be called the purchasing-power-parity theory of exchange rates, namely, that the market exchange rate between two independent moneys will tend to equal the ratio of their purchasing powers. Mises showed that this analysis applies both to the exchange rate between gold and silver—whether or not the two circulate side by side within the same country—and to independent fiat currencies issued by two nations. Wu explained the difference between Mises’s theory and the unfortunately better known version of the purchasing-power-parity theory set forth a bit later by Gustav Cassel. The Cassel version ignores the Austrian emphasis on locational differences in accounting for differences in value of technologically similar goods, and this in turn complements the broader Austrian and classical position that the purchasing power of money is an array of specific goods. This contrasts with Cassel and the neoclassicists, who think of the purchasing power money as the inverse of a unitary price level. Thus Wu stated:

The purchasing power parity theory is that the rate of exchange would be in equilibrium when the “purchasing power of the moneys” is equal in all trading countries. If the term purchasing power refers to the power of purchasing commodities, which are not only similar in technological composition, but also in the same geographical situation, the theory becomes the classical doctrine of comparative values of moneys in different countries and is a sound doctrine. But unfortunately the term purchasing power in connection with the theory sometimes implies the reciprocal of the general price level in a country. While so interpreted the theory becomes that the equilibrium point for the foreign exchanges is to be found at the quotient between the price levels of the different countries. That is . . . an erroneous version of the purchasing power parity theory.7

Unfortunately, Cassel, instead of correcting the error in his concept of purchasing power, soon abandoned the full-parity doctrine in favor of a different and highly attenuated contention that only changes in exchange rates reflect changes in respective purchasing power—perhaps because of his desire to use measurement and index numbers in applying the theory.8

When he set out to apply the theory of marginal utility to the price of money, Mises confronted the problem that was later to be called “the Austrian circle.” In short, when someone ranks eggs or beef or shoes on his value scale, he values these goods for their direct use in consumption. Such valuations are, of course, independent of and prior to pricing on the market. But people demand money to hold in their cash balances, not for eventual direct use in consumption, but precisely in order to exchange those balances for other goods that will be used directly. Thus, money is not useful in itself but because it has a prior exchange value, because it has been and therefore presumably will be exchangeable in terms of other goods. In short, money is demanded because it has a preexisting purchasing power; its demand not only is not independent of its existing price on the market but is precisely due to its already having a price in terms of other goods and services. But if the demand for, and hence the utility of, money depends on its preexisting price or purchasing power, how then can that price be explained by the demand? It seems that any Austrian attempt to apply marginal utility theory to money is inextricably caught in a circular trap. For that reason mainstream economics has not been able to apply marginal utility theory to the value of money and has therefore gone off in multicausal (or noncausal) Walrasian directions.

Mises, however, succeeded in solving this problem in 1912 in developing his so-called regression theorem. Briefly, Mises held that the demand for money, or cash balances, at the present time—say day X—rests on the fact that money on the previous day, day X−1, had a purchasing power. The purchasing power of money on day X is determined by the interaction on day X of the supply of money on that day and that day’s demand for cash balances, which in turn is determined by the marginal utility of money for individuals on day X. But this marginal utility, and hence this demand, has an inevitable historical component: the fact that money had prior purchasing power on day X − 1, and that therefore individuals know that this commodity has a monetary function and will be exchangeable on future days for other goods and services. But what then determined the purchasing power of money on day X−1? Again, that purchasing power was determined by the supply of, and demand for, money on day X−1, and that in turn depended on the fact that the money had had purchasing power on day X−2. But are we not caught in an infinite regression, with no escape from the circular trap and no ultimate explanation? No. What we must do is to push the temporal regression to that point when the money commodity was not used as a medium of indirect exchange but was demanded purely for its own direct consumption use. Let us go back logically to the second day that a commodity, say gold, was used as a medium of exchange. On that day, gold was demanded partly because it had a preexisting purchasing power as a money, or rather as a medium of exchange, on the first day. But what of that first day? On that day, the demand for gold again depended on the fact that gold had had a previous purchasing power, and so we push the analysis back to the last day of barter. The demand for gold on the last day of barter was purely a consumption use and had no historical component referring to any previous day; for under barter, every commodity was demanded purely for its current consumption use, and gold was no different. On the first day of its use as a medium of exchange, gold began to have two components in its demand, or utility: first, a consumption use as had existed in barter and, second, a monetary use, or use as a medium of exchange, which had a historical component in its utility. In short, the demand for money can be pushed back to the last day of barter, at which point the temporal element in the demand for the money commodity disappears, and the causal forces in the current demand and purchasing power of money are fully and completely explained.

Not only does the Mises regression theorem fully explain the current demand for money and integrate the theory of money with the theory of marginal utility, but it also shows that money must have originated in this fashion—on the market—with individuals on the market gradually beginning to use some previously valuable commodity as a medium of exchange. No money could have originated either by a social compact to consider some previously valueless thing as a “money” or by sudden governmental fiat. For in those cases, the money commodity could not have a previous purchasing power, which could be taken into account in the individual’s demands for money. In this way, Mises demonstrated that Carl Menger’s historical insight into the way in which money arose on the market was not simply a historical summary but a theoretical necessity. On the other hand, while money had to originate as a directly useful commodity, for example, gold, there is no reason, in the light of the regression theorem, why such direct uses must continue afterward for the commodity to be used as money. Once established as a money, gold or gold substitutes can lose or be deprived of their direct use function and still continue as money; for the historical reference to a previous day’s purchasing power will already have been established.9

In his comprehensive 1949 treatise, Human Action, Mises successfully refuted earlier criticisms of the regression theorem by Anderson and Ellis.10 Subsequently criticisms were leveled at the theory by J. C. Gilbert and Don Patinkin. Gilbert asserted that the theory fails to explain how a new paper money can be introduced when the previous monetary system breaks down. Presumably he was referring to such examples as the German Rentenmark after the runaway inflation of 1923. But the point is that the new paper was not introduced de novo; gold and foreign currencies had existed previously, and the Rentenmark could and did undergo exchange in terms of these previously existing moneys; furthermore, it was introduced at a fixed relation to the previous, extremely depreciated mark.11 Patinkin criticized Mises for allegedly claiming that the marginal utility of money refers to the marginal utility of the goods for which money is exchanged rather than the marginal utility of holding money itself; he also charged Mises with inconsistently holding the latter view in the other parts of The Theory of Money and Credit. But Patinkin was mistaken; Mises’s concept of the marginal utility of money always refers to the utility of holding money. Mises’s point in the regression theorem is a different one, namely, that the marginal utility-to-hold is itself based on the prior fact that money can be exchanged for goods, that is, on the prior purchasing power of money in terms of goods. In short, that money prices of goods, the purchasing power of money, has first to exist in order for money to have a marginal utility to hold, hence the need for the regression theorem to break out of the circularity.12

Modern orthodox economics has abandoned the quest for causal explanation in behalf of a Walrasian world of “mutual determination” suitable for the current fashion of mathematical economics. Patinkin himself feebly accepted the circular trap by stating that in analyzing the market (“market experiment”) he began with utility while in analyzing utility he began with prices (“individual experiment”). With characteristic arrogance, Samuelson and Stigler each attacked the Austrian concern with escaping circularity in order to analyze causal relations. Samuelson fell back on Walras, who developed the idea of “general equilibrium in which all magnitudes are simultaneously determined by efficacious interdependent relations,” which he contrasted to the “fears of literary writers” (that is, economists who write in English) about circular reasoning.13 Stigler dismissed Böhm-Bawerk for his “failure to understand some of the most essential elements of modern economic theory, the concepts of mutual determination and equilibrium (developed by the use of the theory of simultaneous equations). Mutual determination . . . is spurned for the older concept of cause and effect.” Stigle added the snide note that “Böhm-Bawerk was not trained in mathematics.”14 Thus, orthodox economists reflect the unfortunate influence of the mathematical method in economics. The idea of mutual functional determination—so adaptable to mathematical presentation—is appropriate in physics, which tries to explain the unmotivated motions of physical matter. But in praxeology, the study of human action, of which economics is the best elaborated part, the cause is known: individual purpose. In economics, therefore, the proper method is to proceed from the causing action to its consequent effects.

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. Thus, the man who knew he would be spending $5,000 on 1 January 1977 would lend out all his money to be returned at precisely that date. As Mises stated:

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 . . . When the equilibrium of the evenly rotating economy is finally reached, there are no more cash holdings.15

But if no one holds cash and the demand for cash balances falls to zero, all prices rise to infinity, and the entire general equilibrium system of the market, which implies the continuing existence of monetary exchange, falls apart. As Mises concluded:

In the imaginary construction of an evenly rotating economy, indirect exchange and the use of money are tacitly implied . . . . Where there is no uncertainty concerning the future, there is no need for any cash holding. As money must necessarily be kept by people in their cash holdings, there cannot be any money . . . . But the very notion of a market economy without money is self-contradictory.16

The very notion of a Walrasian general equilibrium is not simply totally unrealistic, it is conceptually impossible, since money and monetary exchange cannot be sustained in that kind of system. Another corollary contribution of Mises in this analysis was to demonstrate that, far from being only one of many “motives” for holding cash balances, uncertainty is crucial to the holding of any cash at all.

That such problems are now troubling mainstream economics is revealed by F. H. Hahn’s demonstration that Patinkin’s wellknown model of general equilibrium can only establish the existence of a demand for money by appealing to such notions as an alleged uncertainty of the exact moments of future sales and purchases, and to “imperfections” in the credit market—neither of which, as Hahn pointed out, is consistent with the concept of general equilibrium.17

With respect to the supply of money, Mises returned to the basic Ricardian insight that an increase in the supply of money never confers any general benefit upon society. For money is fundamentally different from consumers’ and producers’ goods in at least one vital respect. Other things being equal, an increase in the supply of consumers’ goods benefits society since one or more consumers will be better off. The same is true of an increase in the supply of producers’ goods, which will be eventually transformed into an increased supply of consumers’ goods; for production itself is the process of transforming natural resources into new forms and locations desired by consumers for direct use. But money is very different: money is not used directly in consumption or production but is exchanged for such directly usable goods. Yet, once any commodity or object is established as a money, it performs the maximum exchange work of which it is capable. An increase in the supply of money causes no increase whatever in the exchange service of money; all that happens is that the purchasing power of each unit of money is diluted by the increased supply of units. Hence there is never a social need for increasing the supply of money, either because of an increased supply of goods or because of an increase in population. People can acquire an increased proportion of cash balances with a fixed supply of money by spending less and thereby increasing the purchasing power of their cash balances, thus raising their real cash balances overall. As Mises wrote:

The services money renders are conditioned by the height of its purchasing power. Nobody wants to have in his cash holding a definite number of pieces of money or a definite weight of money; he wants to keep a cash holding of a definite amount of purchasing power. As the operation of the market tends to determine the final state of money’s purchasing power at a height at which the supply of and the demand for money coincide, there can never be an excess or a deficiency of money. Each individual and all individuals together always enjoy fully the advantages which they can derive from indirect exchange and the use of money, no matter whether the total quantity of money is great or small. Changes in money’s purchasing power generate changes in the disposition of wealth among the various members of society. From the point of view of people eager to be enriched by such changes, the supply of money may be called insufficient or excessive, and the appetite for such gains may result in policies designed to bring about cash-induced alterations in purchasing power. However, the services which money renders can be neither improved nor impaired by changing the supply of money . . . . The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do.18

A world of constant money supply would be one similar to that of much of the eighteenth and nineteenth centuries, marked by the successful flowering of the Industrial Revolution with increased capital investment increasing the supply of goods and with falling prices for these goods as well as falling costs of production.19 As demonstrated by the notable Austrian theory of the business cycle, even an inflationary expansion of money and credit merely offsetting the secular fall in prices will create the distortions of production that bring about the business cycle.

In the face of overwhelming arguments against inflationary expansion of the money supply (including those not detailed here), what accounts for the persistence of the inflationary trend in the modern world? The answer lies in the way new money is injected into the economy, in the fact that it is most definitely not done according to the Angel Gabriel model. For example, a government does not multiply the money supply tenfold across the board by issuing a decree adding another zero to every monetary number in the economy. In any economy not on a 100 percent commodity standard, the money supply is under the control of government, the central bank, and the controlled banking system. These institutions issue new money and inject it into the economy by spending it or lending it out to favored debtors. As we have seen, an increase in the supply of money benefits the early receivers, that is, the government, the banks, and their favored debtors or contractors, at the expense of the relatively fixed income groups that receive the new money late or not at all and suffer a loss in real income and wealth. In short, monetary inflation is a method by which the government, its controlled banking system, and favored political groups are able to partially expropriate the wealth of other groups in society. Those empowered to control the money supply issue new money to their own economic advantage and at the expense of the remainder of the population. Yield to government the monopoly over the issue and supply of money, and government will inflate that supply to its own advantage and to the detriment of the politically powerless. Once we adopt the distinctively Austrian approach of “methodological individualism,” once we realize that government is not a superhuman institution dedicated to the common good and the general welfare, but a group of individuals devoted to furthering their economic interests, then the reason for the inherent inflationism of government as money monopolist becomes crystal clear.

As the Austrian analysis of money shows, however, the process of generated inflation cannot last indefinitely, for the government cannot in the final analysis control the pace of monetary deterioration and the loss of purchasing power. The ultimate result of a policy of persistent inflation is runaway inflation and the total collapse of the currency. As Mises analyzed the course of runaway inflation (both before and after the first example of such a collapse in an industrialized country, in post-World-War-I Germany), such inflation generally proceeds as follows: At first the government’s increase of the money supply and the subsequent rise in prices are regarded by the public as temporary. Since, as was true in Germany during World War I, the onset of inflation is often occasioned by the extraordinary expenses of a war, the public assumes that after the war conditions including prices will return to the preinflation normal. Hence, the public’s demand for cash balances rises as it awaits the anticipated lowering of prices. As a result, prices rise proportionately and often substantially less than the money supply, and the monetary authorities become bolder. As in the case of the assignats during the French Revolution, here is a magical panacea for the difficulties of government: pump more money into the economy, and prices will rise only a little! Encouraged by the seeming success, the authorities apply more of what has worked so well, and the monetary inflation proceeds apace. In time, however, the public’s expectations and views of the economic present and future undergo a vitally important change. They begin to see that there will be no return to the prewar norm, that the new norm is a continuing price inflation—that prices will continue to go up rather than down. Phase two of the inflationary process ensues, with a continuing fall in the demand for cash balances based on this analysis: “I’d better spend my money on X, Y, and Z now, because I know full well that next year prices will be higher.” Prices begin to rise more than the increase in the supply of money. The critical turning point has arrived.

At this point, the economy is regarded as suffering from a money shortage as evidenced by the outstripping of monetary expansion by the rise in prices. What is now called a liquidity crunch occurs on a broad scale, and a clamor arises for greater increases in the supply of money. As the Austrian school economist Bresciani-Turroni wrote in his definitive study of the German hyperinflation:

The rise of prices caused an intense demand for the circulating medium to arise, because the existing quantity was not sufficient for the volume of transactions. At the same time the State’s need of money increased rapidly . . . the eyes of all were turned to the Reichsbank. The pressure exercised on it became more and more insistent and the increase of issues, from the central bank, appeared as a remedy . . . .

The authorities therefore had not the courage to resist the pressure of those who demanded ever greater quantities of paper money, and to face boldly the crisis which . . . would be, undeniably, the result of a stoppage of the issue of notes. They preferred to continue the convenient method of continually increasing the issues of notes, thus making the continuation of business possible, but at the same time prolonging the pathological state of the German economy. The Government increased salaries in proportion to the depreciation of the mark, and employers in their turn granted continual increases in wages, to avoid disputes, on the condition that they could raise the prices of their products . . . .

Thus was the vicious circle established; the exchange depreciated; internal prices rose; note-issues were increased; the increase of the quantity of paper money lowered once more the value of the mark in terms of gold; prices rose once more; and so on . . . .

For a long time the Reichsbank—having adopted the fatalistic idea that the increase in the note-issues was the inevitable consequence of the depreciation of the mark—considered as its principal task, not the regulation of the circulation, but the preparation for the German economy of the continually increasing quantities of paper money, which the rise in prices required. It devoted itself especially to the organization, on a large scale, of the production of paper marks.20

The sort of thinking that gripped the German monetary authorities at the height of the hyperinflation may be gauged from this statement by the president of the Reichsbank, Rudolf Havenstein:

The wholly extraordinary depreciation of the mark has naturally created a rapidly increasing demand for additional currency, which the Reichsbank has not always been able fully to satisfy. A simplified production of notes of large denominations enabled us to bring ever greater amounts into circulation. But these enormous sums are barely adequate to cover the vastly increased demand for the means of payment, which has just recently attained an absolutely fantastic level . . . .

The running of the Reichsbank’s note-printing organization, which has become absolutely enormous, is making the most extreme demands on our personnel.21

The United States seems to be entering phase two of inflation (1975), and it is noteworthy that economists such as Walter Heller have already raised the cry that the supply of money must be expanded in order to restore the real cash balances of the public, in effect to alleviate the shortage of real balances. As in Germany in the early 1920s, the argument is being employed that the quantity of money cannot be the culprit for inflation since prices are rising at a greater rate than the supply of money.22

Phase three of the inflation is the ultimate runaway stage: the collapse of the currency. The public takes panicky flight from money into real values, into any commodity whatever. The public’s psychology is not simply to buy now rather than later but to buy anything immediately. The public’s demand for cash balances hurtles toward zero.

The reason for the enthusiasm of Mises and other Austrian economists for the gold standard, the purer and less diluted the better, should now be crystal clear. It is not that this “barbaric relic” has any fetishistic attraction. The reason is that a money under the control of the government and its banking system is subject to inexorable pressures toward continuing monetary inflation. In contrast, the supply of gold cannot be manufactured ad libitum by the monetary authorities; it must be extracted from the ground, by the same costly process as governs the supply of any other commodities on the market. Essentially the choice is: gold or government. The choice of gold rather than other market commodities is the historical experience of centuries that gold (as well as silver) is uniquely suitable as a monetary commodity—for reasons once set forth in the first chapter of every money-and-banking textbook.

The criticism might be made that gold, too, can increase in quantity, and that this rise in supply, however limited, would also confer no benefit upon society. Apart from the gold versus government choice, however, there is another important consideration: an increase in the supply of gold improves its availability for nonmonetary uses, an advantage scarcely conferred by the fiat currencies of government or the deposits of the banking system.

In contrast to the Misesian “monetary overinvestment” theory of business cycles, on which considerable work has been done by F. A. Hayek and other Austrian economists, almost nothing has been done on the theory of money proper except by Mises himself. There are three cloudy and interrelated areas that need further elaboration. One is the route by which money can be released from government control. Of primary importance would be the return to a pure gold standard. To do so would involve, first, raising the “price of gold” (actually, lowering the definition of the weight of the dollar) drastically above the current pseudoprice of $42.22 an ounce and, second, a deflationary transformation of current bank deposits into nonmonetary savings certificates or certificates of deposit. What the precise price or the precise mix should be is a matter for research. Initially, the Mises proposal for a return to gold at a market price and the proposal of such Austrian monetary theorists as Jacques Rueff and Michael Heilperin for a return at a deliberately doubled price of $70 an ounce seemed far apart. But the current (1975) market price of approximately $160 an ounce brings the routes of a deliberately higher price and the market price much closer together.23

A second area for research is the matter of free banking as against 100 percent reserve requirements for bank deposits in relation to gold. Mises’s Theory of Money and Credit was one of the first works to develop systematically the way in which the banks create money through an expansion of credit. It was followed by Austrian economist C.A. Phillips’s famous distinction between the expansionary powers of individual banks and those of the banking system as a whole. However, one of Mises’s arguments has remained neglected: that under a regime of free banking, that is, where banks are unregulated but held strictly to account for honoring their obligations to redeem notes or deposits in standard money, the operations of the market check monetary expansion by the banks. The threat of bank runs, combined with the impossibility of one bank’s expanding more than a competitor, keeps credit expansion at a minimum. Perhaps Mises underestimated the possibility of a successful bank cartel for the promotion of credit expansion; it seems clear, however, that there is less chance for bank-credit expansion in the absence of a central bank to supply reserves and to be a lender of last resort.24

Finally, there is the related question, which Mises did not develop fully, of the proper definition of the crucial concept of the money supply. In current mainstream economics, there are at least four competing definitions, ranging from M₁ to M₄. Of one point an Austrian is certain: the definition must rest on the inner essence of the concept itself and not on the currently fashionable but question-begging methodology of statistical correlation with national income. Leland Yeager was trenchantly critical of such an approach:

One familiar approach to the definition of money scorns any supposedly a priori line between money and near-moneys. Instead, it seeks the definition that works best with statistics. One strand of that approach . . . seeks the narrowly or broadly defined quantity that correlates most closely with income in equations fitted to historical data . . . . But it would be awkward if the definition of money accordingly had to change from time to time and country to country. Furthermore, even if money defined to include certain near-moneys does correlate somewhat more closely with income than money narrowly defined, that fact does not necessarily impose the broad definition. Perhaps the amount of these near-moneys depends on the level of money-income and in turn on the amount of medium of exchange . . . . More generally, it is not obvious why the magnitude with which some other magnitude correlates most closely deserves overriding attention . . . . The number of bathers at a beach may correlate more closely with the numbers of cars parked there than with either the temperature or the price of admission, yet the former correlation may be less interesting or useful than either of the latter. The correlation with national income might be closer for either consumption or investment than for the quantity of money.25

Money is the medium of exchange, the asset for which all other goods and services are traded on the market. If a thing functions as such a medium, as final payment for other things on the market, then it serves as part of the money supply. In his Theory of Money and Credit, Mises distinguished between standard money (money in the narrow sense) and money substitutes, such as bank notes and demand deposits, which function as an additional money supply. It should be noted, for example, that in Irving Fisher’s non-Austrian classic, The Purchasing Power of Money, written at about the same time (1913), M consisted of standard money only, while M¹ consisted of money substitutes in the form of bank demand deposits redeemable in standard money at par. Today no economist would think of excluding demand deposits from the definition of money. But if we ponder the problem, we see that if a bank begins to fail, its deposits are no longer equivalent to money; they no longer serve as money on the market. They are only money until a bank’s imminent collapse.

Furthermore, in the same way that M¹ (currency plus demand deposits) is broader than the narrowest definition, we can establish even broader definitions by including savings deposits of commercial banks, savings bank deposits, shares of savings and loan banks, and cash surrender values of life insurance companies, which are all redeemable on demand at par in standard money, and therefore all serve as money substitutes and as part of the money supply until the public begins to doubt that they are redeemable. Partisans of M₁ argue that commercial banks are uniquely powerful in creating deposits and, further, that their deposits circulate more actively than the deposits of other banks. Let us suppose, however, that in a gold-standard country, a man has some gold coins in his bureau and others locked in a bank vault. His stock of gold coins at home will circulate actively and the ones in his vault sluggishly, but surely both are part of his stock of cash. And, if it also be objected that the deposits of savings banks and similar institutions pyramid on top of commercial bank deposits, it should also be noted that the latter in turn pyramid on top of reserves and standard money.

Another example will serve to answer the common objection that a savings bank deposit is not money because it cannot be used directly as a medium of exchange but must be redeemed in that medium. (This is apart from the fact that savings banks are increasingly being empowered to issue checks and open up checking accounts.) Suppose that, through some cultural quirk, everyone in the country decided not to use five-dollar bills in actual exchange. They would only use ten-dollar and one-dollar bills, and keep their longer-term cash balances in five-dollar bills. As a result, five-dollar bills would tend to circulate far more slowly than the other bills. If a man wanted to spend some of his cash balance, he could not spend a five-dollar bill directly; instead, he would go to a bank and exchange it for five one-dollar bills for use in trade. In this hypothetical situation, the status of the five-dollar bill would be the same as that of the savings deposit today. But while the holder of the five-dollar bill would have to go to a bank and exchange it for dollar bills before spending it, surely no one would say that his five-dollar bills were not part of his cash balance or of the money supply.

A broad definition of the money supply, however, excludes assets not redeemable on demand at par in standard money, that is, any form of genuine time liability, such as savings certificates, certificates of deposit whether negotiable or nonnegotiable, and government bonds. Savings bonds, redeemable at par, are money substitutes and hence are part of the total supply of money. Finally, just as commercial bank reserves are properly excluded from the outstanding supply of money, so those demand deposits that in turn function as reserves for the deposits of these other financial institutions would have to be excluded as well. It would be double counting to include both the base and the multiple of any of the inverted money pyramids in the economy.

NOTES

Inflation, Recession, and Stagflation

Gerald P. O’Driscoll, Jr., and
Sudha R. Shenoy

Those who are sufficiently steeped in the old point of view simply cannot bring themselves to believe that I am asking them to step into a new pair of trousers, and will insist on regarding it as nothing but an embroidered version of the old pair which they have been wearing for years (John Maynard Keynes, “The Pure Theory of Money: A Reply to Dr. Hayek,” Economica 11 [November 1931]:390).

The major macroeconomic problem facing Western economies today is that of explaining why the supposedly mild inflations of the two decades following World War II turned into the intractable “stagflation” besetting theorist and policymaker alike. The two major analytical approaches to the problem, that of the Keynesians and that of the monetarists, have a serious failing in common: they ignore the real side of the economy and hence the real maladjustments brought about by a monetary policy that interferes with the coordination of economic activities. Both views implicitly assume that the real side of the economy is always in some sort of long-term equilibrium, in which money influences only the price level or money income and not the structure of relative prices or the composition of real output. As we intend to show, such a point of view belongs to a stage in the history of economic thought before the structure of output and the influence of prices on production had been worked out.

We shall also offer an exposition of an alternative analysis derived from the Austrian school of economic thought, especially from the writings of Friedrich A. Hayek. In so doing, we shall indicate how a Hayekian analysis of the effects of monetary changes on the structure of prices and outputs enables us to delve beneath the monetary surface to the real underlying phenomena and thereby call attention to the misallocation resulting from a monetary system that discoordinates economic activity.

Not all possible alternatives to the Austrian view will be covered. For instance, we shall not examine the extensive neo-Ricardian critiques of the current orthodoxy advanced by Joan Robinson, Nicholas Kaldor, and Piero Sraffa, since we regard these criticisms as part of a more general attack on subjectivist marginalist economics. Nor shall we consider in detail the work of Robert W. Clower and Axel Leijonhufvud, which in part complements our own work here.1 We would argue, however, that virtually all writers and all non-Austrian schools of thought have ignored the importance of Hayek’s work in explaining important features of the business cycle.

I

World War II marked a great shift in the character of the macroeconomic problems developed countries had to face. In the years after World War I, policymakers had to cope with a “typical” economic crisis, which was followed by what in the 1920s had been taken to be a stable expansion and then by a second crisis, only this time one of unprecedented intensity and length. However, after 1945, the problem turned around completely and became that of gently (and later, more rapidly) rising prices. In eleven major developed countries, prices declined hardly at all, and when they did, it was only for a couple of years during the early fifties.2 Price indices remained stable for some years in several of these countries, but these periods of relative price stability were outnumbered by years of rising prices, so that in effect prices have been rising more or less steadily ever since the end of World War II.

Generally output rose pari passu with prices. Indeed, the countries of the European Economic Community, together with the outstanding examples of Israel and Japan, were generally extolled for their economic growth record in comparison with such “slow growers” as the United Kingdom.3

However, two ominous symptoms of underlying structural distortions then appeared: annual rates of price increases sharply accelerated, running in most developed countries well into two-digit figures, and rates of increase in output began to slacken. Unemployment percentages, at historic lows since the late forties, started an upward climb, and every attempt to reduce the rate of price increase brought fresh upward jumps in unemployment and excess industrial capacity. Forecasts of the Organization for Economic Cooperation and Development described the price situation as “worrying” and reported that, although price inflation continued at historically high rates (in excess of 12 percent per annum in early 1974), growth continued to decelerate (that is, aggregate demand fell in relation to aggregate supply). “Over the last few years unemployment seems to have risen in relation to demand pressures,” and the “unemployment rate at the peak of the boom is higher than at earlier peaks.”4

This stagflation dilemma seemed far more serious in the United Kingdom than elsewhere. Retail prices rose every year after 1945, yet growth rates in output remained low compared to the European Economic Community. Periodic attempts to bolster the rate of growth regularly ran into balance-of-payments problems leading to the well-known “stop-go” cycle. Here, too, the interval between “go” and “stop” steadily decreased. For example, in 1974 the chancellor of the exchequer chose to introduce “reflationary” preelection measures hardly two months after a “deflationary” postelection budget.

In the United Kingdom more than in any other developed country, acceleration in the rate of price increase was combined not merely with a low rate of growth in output but with a zero or even a negative growth rate. The rate of increase in the retail price index exceeded 10 percent well before it did in any other developed country, and even before this happened, the retail price index began climbing well ahead of output. In late 1974 the price increase showed every sign of continuing into the 20 percent range, while output continued to slacken. For the United Kingdom an inflationary depression in the eighties seemed quite likely.5 While inflation in the United States was not so serious as that in the United Kingdom, there was every indication that the United States was but a few years behind the United Kingdom in this respect. Unemployment rates were higher in the United States than in the United Kingdom. And some would argue that the United States was already experiencing the inflationary depression feared for the United Kingdom.

What went wrong? Why did the gently rising price level of the fifties and the sixties give way to two-digit increases, which hardly anyone expected? Why did unemployment rear its head with every slackening of the rate of price increase?

THE KEYNESIAN DIAGNOSIS

Many Keynesians view the post-1945 situation as one of “cost inflation,” that is, of rising cost levels pushing up the price level, with a passive monetary system furnishing the necessary finance.6 Costs, the active variable, determine prices, while the money supply adapts passively.7 Attempts to control the supply of money, rather than to control costs directly, must create unemployment without reducing prices, since costs continue to rise. However, if costs can be controlled directly, for example, by some kind of incomes policy, it would be possible to achieve both full employment and a stable price level.8 And the thirties are viewed as a warning (not only by the Keynesians but others as well), as an example of what happens when money income and expenditure are not expanded sufficiently to restore full employment.9

This view epitomizes the policy teachings of modern macroeconomics. The modern treatment of interest rates is a good example of the way Keynesian analysis neglects the microeconomic significance of the structure of relative prices and outputs that actually characterizes the real world. The interest rate—or market spectrum of interest rates—is the closest approach in macroeconomics to anything like a price. Of course, in the one-or-two-commodity worlds usually treated in macromodels, changes in interest rates have—by hypothesis—no micro implications.10 But even here the Keynesian approach offers no long-run theory of interest rates or even bothers to discuss in detail the real factors affecting the money rate of interest.11 What we have instead is an analysis of the impact on interest rates of changes in the rate at which the money stream enters the money market. This may give us a hypothesis for explaining short-run changes in market interest rates, but it is not itself a theory of interest. As D. H. Robertson pointed out, in his classic characterization of Keynes’s liquidity-preference theory:

Thus the rate of interest is what it is because it is expected to become other than it is; if it is not expected to become other than it is, there is nothing left to tell us why it is what it is. The organ which secretes it has been amputated. And yet it somehow still exists—a grin without a cat.12

In the Keynesian macro approach prices remain completely rigid in both absolute and relative terms. Changes in the structure of relative prices are ignored as analysis often explicitly assumes that prices remain always “at their historic levels.”13

In a similar manner, the structural composition of output is also considered irrelevant; indeed, the Keynesian concept may be said to be that of full unemployment, that is, the implicit assumption that all goods and services are available in abundance, so that output and employment can be increased by all firms simultaneously. Or, to put this point somewhat differently, the level of unemployment and excess capacity at the bottom of the cycle is assumed to be uniform throughout the economy. The substantial variations, in both unemployment and excess capacity, as among different firms, industries, and regions, are disregarded in the Keynesian framework as having little analytical significance.

In such a scheme, then, the level of output and employment depends on the level of monetary expenditure or, in more sophisticated variants, the rate of increase of monetary expenditure. The supply side is implicitly ignored, and, as just mentioned, the concentration on levels of utilization (of labor and other factors) implies that on the real side there is a constant equilibrium being maintained in the structure of output.

It might also be pointed out that for the Keynesian, an inflationary recession (that is, a rising price level and a rising unemployment rate) is a particularly difficult problem with which to deal. Inflation should only result when aggregate demand continues to rise as full employment is reached.

THE MONETARIST POSITION14

At the other extreme (or so it seems) we have Milton Friedman and the monetarist school of thought. Yet Friedman also interprets the historical experience of the twenties and the thirties in purely monetary terms. For him also, as we shall see, there is no real problem of coordination to worry about at the macroeconomic level.

The monetarist approach may be represented by a quotation from John S. Mill:

In considering value, we were only concerned with causes which acted upon particular commodities apart from the rest. Causes which affect all commodities alike do not act upon values. But in considering the relation between goods and money, it is with the causes that operate upon all goods whatever that we are especially concerned. We are comparing goods of all sorts on one side, with money on the other side, as things to be exchanged against each other.15

For Mill, as for many of the classical economists, changes in the money supply affect aggregate spending but not relative prices. Pricing—the determination of value—is not affected by monetary disturbances. For the most part, Mill analyzed changes in the quantity of money in terms of what the modern economist would describe as a discrepancy between actual and desired cash balances. The real side of production is assumed to be largely unaffected.16

Monetarism has hardly advanced beyond the classical position; accordingly, it is not surprising that the classical economists can sound quite modern. In his analysis of some specific problems in microeconomics, Friedman adopted what is basically the outlook of methodological individualism. But in his monetary theory (and in that of others of the same school) we find, quite inconsistently, an aggregative analysis, utilizing holistic macroconstructs that are treated (wrongly) as if they interacted directly with one another. This procedure entirely ignores the microeconomic pricing process, which actually determines the real structure of prices and output.17 Monetarism then does not differ in its fundamental approach from the other dominant branch of orthodox economics, that of Keynesianism. A microtheorist is distinguished by his adherence to the principle of methodological individualism when answering all questions; that is, he analyzes economic problems in terms of the effects of a given change on the expected costs and benefits facing transactors. A microeconomist is thus led to analyze (among other things) the market process and its complex interrelationships. In this respect, at least, Friedman is not a consistent methodological individualist.

Friedman argued that real factors determine real magnitudes. Real forces thus determine real income, while monetary forces determine nominal income, with the price level as the joint outcome of the two forces. (Such an approach differs little from the older views of Irving Fisher and is open to all the criticisms leveled against that approach.)18 To the foregoing, Friedman appended a short-run adjustment process “in which the rate of adjustment in a variable is a function of the discrepancy between the measured and the anticipated value of the variable or its rate of change, as well, perhaps, as of other variables or their rates of change.”19

Friedman hypothesized such an adjustment process because for him the key question of monetary theory is the reaction to a discrepancy between the nominal quantity of money supplied and the nominal quantity demanded. Monetary expansion, then, affects only the price level; there are no structural maladjustments, while depressions, on the other hand, are largely, if not entirely, the outcome of a decline in the rate of growth of the stock of money. True, in the transition from a rising to a stable price level, there may be some unavoidable transitional decline in output and employment, as money prices adjust themselves to the reduced rate of increase in the stock of money. But provided this reduction is gradual, there need not be any significant impact on employment and certainly not a fall in aggregate output. A monetary expansion, on the other hand, simply reverses this process: initially, as the money supply expands and prices rise, wages (and other costs) fail to rise (because the information has not yet spread throughout the economy), and mostly profits increase. Hence output and employment expand—temporarily. Once nominal wages and other costs are bid up in line with the new price level, profits shrink to their “normal” level, as determined by the real elements of the situation. There arc-no prolonged misallocations anywhere. The pattern of output is untouched. If we wish to push unemployment below its “natural” level and expand the money supply to this end, larger and larger increases will become necessary, as the system adjusts to the rises in money prices. But a serious recession or depression need not result, since monetary expansion creates no real distortions, and the banking system is now geared to prevent any serious deflations in the stock of money.20 Consistent with these views, Friedman attached no real significance to the monetary expansion of the twenties inasmuch as the price level remained fairly stable, while in the early thirties the substantial decline in output and employment in United States was due directly to the substantial contraction in the stock of money during the years 1929–32 but not to what had preceded it.

The monetarist position may be restated as follows: in real terms, prices are always tending to their long-term equilibrium level; monetary changes affect only their nominal height and have no lasting impact on production. Because Friedman viewed underlying economic reality as being adequately described by long-run Walrasian equations, such a position is the only reasonable one—since long-run equilibrium by definition excludes any real disequilibrium! Nor could Friedman consistently superimpose imperfect anticipations onto a system in which all expectations are by definition consistent and realized. Finally, in the ad hoc “adjustment process” Friedman postulated, he failed to distinguish between price changes that coordinate production and those that do the opposite! In other words, he assumed that price changes represent movements from one equilibrium to another. But the proposition under question is precisely whether price changes can be assumed to automatically coordinate: the Hayekian analysis, as will be shown, demonstrates that under certain monetary conditions some price changes may seriously discoordinate production. In short, in the terminology originally introduced by Hayek, money is not always “neutral.” In any case, general equilibrium equations, being solely definitional, leave out of consideration the whole market process—indeed, such equations can tell us nothing about this intertemporal process.21 But it is precisely these interrelated price changes that guide production over time and therefore cannot be overlooked.

The aggregative macro constructs, on which Friedman and the monetarists base their analyses, are in the end similar to other orthodox schools of thought (including the Keynesians, as Friedman readily acknowledges).22 In relying on these constructs the monetarists appear to be unaware of the real effects of money on the economic system—money’s effect on individual prices and price interrelationships and hence on the whole structure of outputs and employments. By ignoring the structure of production and the influences of prices on production, the monetarist analysis shares a common deficiency, not only with the Keynesians, but indeed with the entire analytic framework of the current orthodoxy. The monetarists no less than the Keynesians lay themselves open to Hayek’s criticism that such thinking takes “us back to the pre-scientific stage of economics, when the whole working of the price mechanism was not yet understood, and only the problems of the impact of a varying money stream on a supply of goods and services with given prices aroused interest.”23

II

As we have seen, the principal deficiency of both the Keynesian and the monetarist approach is the neglect of the microeconomics of business cycles. Furthermore, it is doubtful whether even the existence of money can be adequately accounted for in a Walrasian framework.24 In any case, Keynesians and monetarists alike fail to find any place for money in the pricing process: money is given no role in determining relative prices.

The Austrian contribution to monetary theory is two-fold: First, it emphasizes the role of money in the pricing process and incorporates money—or, more precisely, changes in the stream of money payments—into the determination of relative prices. Second, it analyzes the effects of such money-induced relative price changes on the time structure of production, that is, the capital structure.

Carl Menger provided the theoretical framework for explaining why a medium of exchange was used.25 Then, after Knut Wicksell drew attention to the failure of the classical quantity theory to explain how changes in the money supply affect prices,26 Mises, building on Menger and Wicksell, showed more completely how money could be integrated into general economic theory. He went on to outline a theory of cyclical fluctuations in which monetary disturbances lead to misallocations.27 Hayek built on the theories of Menger, Böhm-Bawerk, Wicksell, and Mises to amplify and expand the Austrian monetary tradition, especially in capital and business cycle theory.28 The analysis that follows builds on this tradition.

MONETARY EXPANSION, PRICING, AND RESOURCE ALLOCATION

Monetary changes are not neutral—they do not affect all prices uniformly so as to change their nominal height but leave relative price relationships unaltered. In reality money does not enter the economy by way of a simple uniform change in all money balances, as many textbook writers like to assume. Rather, newly created money always enters the economy at a specific point and is spent on certain specific goods before gradually working through the system.

Thus some prices and expenditures are altered first, and other prices and expenditures, later. As long as the original monetary change is maintained, this monetary “pull” on price interrelationships will persist. This point is fundamental to the analysis that follows.

Hayek likened the effects of money on pricing to the process of pouring a viscous liquid (honey in his example) into a vessel:

There will, of course, be a tendency for it to spread to an even surface. But if the stream (of honey) hits the surface at one point, a little mound will form there from which the additional matter will slowly spread outward. Even after we have stopped pouring in more, it will take some time until the even surface will be fully restored. It will, of course, not reach the height which the top of the mound had reached when the inflow had stopped. But as long as we pour at a constant rate, the mound will preserve its height relative to the surrounding pool.29

Resource allocation will not be left unchanged as a result of these relative price changes. At the point at which the new money enters the economy, prices will rise relative to prices elsewhere. The pattern of outputs will be altered correspondingly. Monetary expansion also prevents some prices from falling that otherwise might. Thus some businesses make profits that otherwise would have losses, and workers are employed in jobs they otherwise would leave. Another result of the monetary expansion is that more new and different kinds of businesses are started. Firms are also led to embark on new and/or different lines of production. In short, the pattern of expenditures, resource allocation, and above all relative prices is changed by monetary expansion.

Typically an expansion of the money supply takes the form of an increase in bank credit. (While governments can simply print extra currency, they usually prefer less obvious methods of reaching this objective and thereby bridging the chronic gap between fiscal incomes and expenditures.) Let us consider the impact of an increase in the rate of growth of bank credit. Bank-credit expansion at first reduces interest rates below the level they otherwise would attain. The overall pattern of expenditures is necessarily altered: investment expenditures rise relative to current consumption expenditures and to savings, the increase being measured approximately by the increase in the money supply.

Monetary expansion thus leads to a discoordination between the saving and investment plans of the nongovernmental public. The Keynesian and the monetarist would find little to quarrel with in the analysis up to this point: the former would agree that if planned investment exceeds planned savings, incomes and output and possibly prices will rise; the latter would say that an increase in the stock of money will raise incomes and prices and perhaps output. The Austrian analysis, however, goes farther—to detail the changes in the pattern of expenditures and hence in the pattern of outputs, resulting from the consequent changes in relative prices.

MONETARY EXPANSION AND THE PRODUCTION STRUCTURE

As we have just seen, in crudely aggregative terms, monetary expansion leads initially to a drop in interest rates relative to what they would have been and a rise in investment expenditures relative to consumption expenditures, that is, a decline in the uniform rate of discount will raise the demand-price schedule for durable capital goods—and even more so, for the more durable goods—in relation to the demand-price schedule for current consumption services. But this is only the beginning.

There has not been a change in the supply of capital goods. Capital is not a homogeneous stock but an interconnected structure of interrelated capital goods. By disrupting price signals, the effect of monetary expansion is to throw this structure out of coordination.

In the Hayekian view, production is seen as a series of “stages,” beginning with final consumption and extending through to stages systematically and successively farther removed from this final stage.30 Factor services are applied to the unfinished products moving through these stages. In other words, production consists of a series of interrelated processes in which heterogeneous capital goods are grouped in specific combinations, together with land and labor services.

Capital goods usually and land and labor to some extent are specific to particular stages of production. Capital goods are thus in general not homogeneous and substitutable; they are heterogeneous and complementary and usable only in specific combinations: for example, a machine from a shoe factory cannot be combined at random with a machine from an automobile plant to produce some third product.31 Generally, if capital investments (such as shoe factories and automobile plants) are to add more to final output than any other capital combination, they must fit into an integrated production structure completed to the final consumption stage, that is, they must fit into an interlinked series of complementary investments.32

The increased bank credit flowing into the system at temporarily depressed interest rates alters the relative profitability of capital invested in different stages; the streams of quasi-rents accruing to the various capital goods are changed; and these goods are rearranged into different capital combinations. At the lower interest rates, certain formerly unprofitable investments become profitable. Additional bank credit does not produce additional labor and land services; hence the new investments must necessarily use relatively less labor. Because more money is available and interest rates are lower, factor rental prices are bid up relative to product prices, that is, real factor costs increase.33 Hence entrepreneurs try to adopt less labor-intensive (that is, more “capitalistic”) production methods. Demand for raw materials increases also.

Conversely, certain formerly profitable investments now become unprofitable: returns decline on capital goods that are usable only in relatively more labor-intensive methods and that cannot readily be adapted to the use of less labor. Demand for the different sorts of capital goods depends on relative factor costs and on the expected returns from using the machines to produce other products. Firms producing capital goods geared to unprofitable capital combinations find that they face increased factor costs while demand for their machines is falling off. Hence these firms (or lines of production) contract, while other firms producing goods adapted to the newer, more profitable capital combinations find demand rising and increase their output.

Changing price signals reduce profits on production for current consumption and increase profits on production for future consumption, thus altering rates of return on the different capital combinations involved.34 Returns decline in production stages nearer to consumption, while returns increase in stages farthest from final consumption. Nonspecific resources are thus shifted from the former to the latter: output of consumer goods declines, while the pattern of production of capital goods is so altered as to produce goods that fit into a production structure extending through more stages than was previously possible.

In order that these investments may all be completed down to the final consumption stage, it is necessary that the requisite resources continue to be released from consumption, that is, that a decline in consumption output be maintained until, the new production structure is completed. It must be remembered that, because of intertemporal complementarily, a machine whose usefulness depends on the construction of additional capital goods will be economically useless if the-requisite resources are diverted elsewhere (that is, to the production of consumption output in this case). In order to complete all the capital combinations appropriate to an extended production structure, capital goods are now required that, given the intensity of consumption demand, are not available.

THE SELF-REVERSIBILITY OF MONETARY CHANGES

Consumption demand begins to increase as a result of the increased money incomes that factor owners have been receiving as a consequence of the increase in bank money. By hypothesis there has been no change in the rate of saving out of income. As these incomes are spent, the increased consumption expenditure meets an attenuated supply of consumer goods. Prices of consumer goods now, at this later stage, begin to rise relative to the prices of unfinished products, especially those farthest away from the final consumption stage. The process described earlier is now reversed: returns rise in stages nearer consumption, while returns decline in stages farthest from consumption. Nonspecific resources are once more drawn back into the production of consumer goods. All those capital goods intended for a different production structure have now to be readapted, to fit another, less capitalistic structure, with concomitant losses and unemployment. These losses are particularly heavy on those capital goods most suited only to a more capitalistic structure. Capital goods that are profitable to produce only at the lower rates of interest have been overproduced. They have been overproduced because the price signals generated by the hypothesized monetary policy have resulted in the production of inappropriate combinations of capital goods. Capital goods appropriate to the real factors (including transactors’ time preferences or propensity to consume out of income) have been under-produced. In summary, the attempted extension of the production structure cannot be completed for lack of resources.

Monetary expansion began by lowering interest rates. Entrepreneurs, misled by the uncoordinated price signals, attempted to reduce all marginal rates of return to the same level. But in attempting to do so, they actually drove up ex post returns on some goods to levels higher than these interest rates.35 Monetary expansion thus induces disproportionalities in the production of capital goods that are revealed in the depression: there is overproduction in some lines, underproduction in others. The focus on the disproportionalities that occur in a cyclical process and the emphasis placed on these discoordinating price signals are perhaps the distinguishing features of Austrian, or Hayekian, analysis. It is precisely these effects that are lost in modern aggregative macromodels.

From the foregoing analysis, it is clear that the aggregation of individual investment-demand curves into one aggregate-investment curve has no price-theoretic foundation. Demand for any capital good depends on its position in the production structure and the profitability of integrating it into different and varying capital combinations. Equally, changes in interest rates affect prices and supplies, not merely of produced goods used in further production, but also of land and labor services. In short, monetary expansion affects not merely “the” interest rate but alters an enormous complex of price-cost margins and resource allocations; “the interest rate” is merely an extremely clumsy and misleading shorthand phrase covering this vast and intricate web of interrelationships.

Monetary expansion thus sets in train an unsustainable change in the pattern of production, a change that must eventually be modified and reversed. Initially, as money incomes rise, the effects of the expansion may appear to be beneficial. But it is now that the unsustainable misallocations are being made, as prices of unfinished products rise relative to consumer goods prices. As the money permeates through the system, this relative price change is reversed, and consumer goods prices rise. The cluster of misallocations now stands revealed in the form of losses and unemployment, additional to those necessary for the continuous adaptation of production to changing circumstances. More specifically, resources become unemployed in stages farthest from consumption. This unemployment is reduced as consumer goods production picks up. Continuous monetary expansion can only perpetuate this cyclical discoordination in the capital structure and thus raise losses and unemployment above the level they would otherwise reach.

Such expansion cannot prevent real scarcities from manifesting themselves. Prices may be initially and temporarily influenced in a direction opposite to that of the underlying real factors. But it is not as if there were an infinite array of prices consistent with the real factors. Prices reflect not only monetary disturbances but also real influences—tastes, technology, and, above all, real scarcities.

Consequently, although monetary expansion has real misallocating effects, these “purely” monetary changes are self reversing.36 Most contemporary economists would be chary of accepting this proposition. This reluctance stems, we feel, from the current approach, which assumes that output always has its equilibrium composition, and which treats money as determining only the nominal heights of prices that are always at their real equilibrium levels. If money has no real effect whatsoever, then there is none to reverse, and furthermore there are no misallocations to correct.37

A final word: a monetary disturbance differs substantially from, for example, a tax-and-subsidy scheme. Taxes and subsidies do indeed reduce outputs of the taxed commodities while stimulating production of the subsidized ones. But there is no purely economic reason why taxes and subsidies, once imposed, need ever be removed. These disturbances merely lead to a new and stable allocation of resources, which persists as long as the taxes and subsidies continue. In the tax-cum-subsidy case, economic behavior is coordinated. There is no self-reversal.

PRICE EXPECTATIONS AND RESOURCE ALLOCATION

We have seen that monetary expansion systematically transmits misinformation throughout the economic system by moving prices in a direction opposite to that required by real structural factors. However, as expansion continues, price increases come to be expected.38 Real scarcities and changed price expectations together serve to reduce somewhat those profit margins widened by purely monetary factors. If entrepreneurs find that ex post rates of return on certain goods (that is, consumer goods in general) are persistently higher than were expected ex ante, then they will come to anticipate this. Entrepreneurs will be willing to pay more to hire factors to produce those goods whose profit margins have proved to be greatest. Thus factor costs increase and profit margins decline for the producers of these capital goods appropriate to the lower rate of interest. Demand for these capital goods declines as entrepreneurs come to demand a different set of heterogeneous capital goods. Hence even with a constant rate of monetary expansion, we have the onset of the recessionary symptoms of a corrective reallocation. In these circumstances, if policymakers wish to raise apparent profit margins on firms producing inappropriate capital combinations to their previously inflated level, they must accelerate the monetary expansion. The ultimate limit to such a monetary policy is the abandonment of that money as a medium of exchange.

But even if monetary expansion proceeds at a constant rate, price expectations and real scarcities by no means obviate all the discoordinating effects of such a continuous disturbance; for it is not a matter of transactors’ coming to anticipate the average increase in a set of prices—that is, the change in a price index. The impact on individual prices is still somewhat unpredictable, and hence profit margins on particular capital goods will continue to differ from expectations, because of purely monetary influences; some capital dislocation will thus continue.39

THE INADEQUACIES OF A PURELY MONETARY APPROACH

We may now see the inadequacies of the Keynesian approach that argues that, when there is excess capacity and unemployed labor in both capital and consumption goods industries, credit expansion permits higher employment and output. If the excess capacity is idle because it has been malinvested and hence cannot be fitted into the capital structure, the increased credit can only add to these misallocations and thus create further potential future idleness for both capital and labor resources. As Hayek incisively noted:

It has of course never been denied that employment can be rapidly increased, and a position of ‘full employment’ achieved in the shortest possible time by means of monetary expansion—least of all by those economists whose outlook has been influenced by the experience of a major inflation. All that has been contended is that the kind of full employment which can be created in this way is inherently unstable, and that to create employment by these means is to perpetuate fluctuations. There may be desperate situations in which it may indeed be necessary to increase employment at all costs, even if it be only for a short period . . . . But the economist should not conceal the fact that to aim at the maximum of employment which can be achieved in the short run by means of monetary policy is essentially the policy of the desperado who has nothing to lose and everything to gain from a short breathing space.40

If many contemporary economists refer to recessions or depressions today, it is almost invariably to their purely monetary aspects. Thus Friedman argued that “the American economy is depression-proof”: a drastic monetary decline on the lines of 1930–33 is now impossible because of deposit insurance and banking and fiscal changes.41 Paul W. McCracken concurred that economic management “can probably avert a major and a generalized depression”—financial collapse on the 1930s scale has been so rare that it would be premature to anticipate something similar. (However, he sternly warned companies and financial institutions against the risks of unwise financing policies.)42 Harry G. Johnson stated that it is a “virtual certainty that nations will never again allow a massive world recession to develop” since “their economists would know better than to accept disaster as inevitable or inexplicable.”43 Haberler entitled the foreword to the 1964 edition of his Prosperity and Depression “Why Depressions Are Extinct.” He cited the strength of the United States financial structure, deposit insurance, refusal to tolerate a wholesale deflation, and the powerful built-in stabilizer of the government budget. By preventing a decline in expenditure, this policy has “proved to be a very powerful brake on deflationary spirals and has been a major factor in keeping depressions mild.” Outlining the main features of business cycles, he stated:

A very significant fact is that the wholesale price level almost always rises during the upswing and falls during the downswing, and the money values—payrolls, aggregate profits etc.—always go with the cycle. This proves that changes in effective demand, rather than changes in supply, are the proximate cause of the cyclical movement in real output and employment.44

None of these statements deal with the real misallocations resulting from monetary expansion or with the counteracting forces then set in motion. As we have seen, such counteracting forces, that is, recessionary symptoms, may appear to be (temporarily) fended off only if monetary expansion proceeds at an accelerating rate. If an expansion proceeds at a steady rate, recessionary symptoms appear nonetheless, and their onset is more rapid if the expansion decelerates.

STAGFLATION AND MONETARY ACCELERATION

In either case, it is the investment goods industries farthest from the production of consumer goods that feel the pinch first. If the monetary expansion continues steadily with the relative increase in consumer goods prices, firms nearer consumption bid away nonspecific resources from these industries, which now find that their costs rise faster than their selling prices. If the expansion slows down, there is an unambiguous decline in monetary demand for the investment projects begun at the lower interest rates. But even while unemployment and malinvested excess capacity appear in stages farthest from consumption, the incomes generated in the expansion are still working through the system. Consumer goods industries will maintain and even increase their demand for factor services: whereas at the beginning of the expansion these industries were outbid for factor services, they now face both an increase in demand and an increasing supply of nonspecific factors, as these are released by firms farther from consumption. Consumer prices may well continue to rise, but much depends on how rapidly output can be increased in these industries and nonspecific resources shifted back into consumer goods production. Mitigation of the level of employment also depends on both these elements.

From this analysis it is clear that attempts to maintain inflated capital values and incomes in the capital goods industries most affected would perpetuate the misallocation. Undoubtedly, there will be political pressure to do this:45 the incomes of specific factors are most strongly affected by changes in demand for their services. But reflation—accelerated expansion—will lead to further maladjustments. Moreover, given the continuous steep rise in consumer prices, there will also undoubtedly be an opposing pressure from groups whose incomes lag behind. This pressure will often take the form of controls on prices (particularly those of consumer goods). Consumer price controls can only exacerbate the situation. By reducing returns in the consumer goods industries, they intensify the shortage of consumption goods.

As we have seen, it is the rise in consumption expenditures that precipitates the market pressure for resource reallocation. Attempts to stimulate consumption would intensify these reallocative pressures. A rise in voluntary saving, on the other hand, would help salvage some of the malinvestments. But these misallocations were created by the monetary expansion; as long as expansion continues, the capital structure will be dislocated, and malinvestments will arise, only some of which are salvageable.

To summarize: Under the impact of a monetary disturbance, prices will transmit misinformation. The revelation of this misinformation and its correction constitute a recession. The abnormal rise in losses and unemployment is the counterpart to the misallocations created by the misinformation. In short, monetary expansion and recession are inseparable!

If the expansion is halted, the recession is precipitated rapidly. It may be extensive and deep. But once the readjustment is completed and a sustainable pattern of output and employment established, there need be no further allocative difficulties and certainly no currency depreciation.

If monetary expansion continues, recessionary symptoms of greater and greater intensity appear. But the readjustment will not be wholly completed. The pattern of output and employment is continuously dislocated. Eventually, losses and unemployment persist in rising and continue at ever higher levels despite the continuing expansion.46

If the expansion is repeatedly accelerated to overcome the recession, the outcome is obvious. Such a situation may well come to face the developed economies of the Western world, unintentionally, no doubt as the consequence of the cumulative outcome of successive decisions to expand the money supply in the face of the threatening depression. The economists quoted here assure us that our financial system will never permit another Great Depression. Can they also assure us that it will never permit a hyperinflation?

Samuelson seemed to think not. He pointed out that monetary expansion occurs in response to “populist” pressures to “avoid policies that would worsen short-run unemployment and stagnation problems.” He therefore saw the outlook as one of “creeping or trotting inflation. The problem is how to keep the creep or trot from accelerating. This includes the challenge of finding new macroeconomic policies beyond conventional fiscal and monetary policies that will enable a happier compromise between the evils of unemployment and of price inflation.” But he stressed that “a Draconian policy of insisting upon stable prices at whatever cost to current unemployment and short-run growth” would be a “costly investment in fighting inflation,” since he saw no guarantee “that even in the longest run the benefits to be derived from militant anti-inflationary policies don’t carry excessive costs as far as average levels of unemployment and growth are concerned.” He went on to warn that “mankind at this stage of the game can ill afford to make irreversible academic experiments whose outcomes are necessarily doubtful” and whose implementation would exacerbate political tensions. He was confident such an anti-inflation policy “will assuredly never be followed.”47

Truly, inflation does leave us holding a “tiger by the tail,” as Hayek remarked:

Now we have an inflation-borne prosperity which depends for its continuation on continued inflation. If prices rise less than expected, then a depressing effect is exerted on the economy . . . .to slow down inflation produces a recession. We now have a tiger by the tail: how long can this inflation continue? If the tiger (or inflation) is freed, he will eat us up; yet if he runs faster and faster while we desperately hold on, we are still finished! I’m glad I won’t be here to see the final outcome.48

NOTES

[1.]For an elaboration of a number of issues raised in this paper, see Israel M. Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973).

[2.]Joseph A. Schumpeter, Capitalism, Socialism, and Democracy (New York: Harper & Row, 1942), pp. 81–106.

[3.]Oscar Morgenstern, “Thirteen Critical Points in Contemporary Economic Theory: An Interpretation,” Journal of Economic Literature 10(December 1972):1163–89.

[4.]Ludwig M. Lachmann, “Methodological Individualism and the Market Economy,” in Roads to Freedom: Essays in Honour of Friedrich A. von Hayek, ed. Erich Streissler et al. (London: Routledge & Kegan Paul, 1969), p. 89.

[5.]Alfred Marshall, Principles of Economics, ed. C. W. Guillebaud, 2 vols. (London: Macmillan & Co., 1961), 1:345–48; Marshall sometimes used the Walrasian approach (ibid., pp. 333–36).

[6.]Lionel Robbins, An Essay on the Nature and Significance of Economic Science (London: Macmillan & Co., 1962), pp. 1–23.

[7.]Ludwig von Mises, Human Action: A Treatise on Economics (New Haven: Yale University Press, 1949), pp. 11–142; on the comparison of Misesian and Robbinsian notions, see Israel M. Kirzner, The Economic Point of View (Princeton: D. Van Nostrand, 1960), pp. 108–85.

[8.]In the preface to the first edition of his book, Robbins acknowledged his debt to Mises (On the Nature, pp. xv-xvi).

[9.]Kirzner, Competition, pp. 75–87.

[10.]Edward Hastings Chamberlin, The Theory of Monopolistic Competition, 7th ed. (Cambridge: Harvard University Press, 1962), pp. 123–29.

[11.]See the literature cited in Kirzner, Competition, pp. 141–69.

[1.]Karl R. Popper, The Poverty of Historicism (London: Routledge & Kegan Paul, 1957).

[2.]Ludwig M. Lachmann, “Methodological Individualism and the Market Economy,” in Roads to Freedom: Essays in Honour of Friedrich A. von Hayek, ed. Erich Streissler et al. (London: Routledge & Kegan Paul, 1969), p.91.

[1.]John R. Hicks, Capital and Time: A Neo-Austrian Theory (Oxford: Clarendon Press, 1973).

[2.]John R. Hicks, “Capital Controversies: Ancient and Modern,” American Economic Review 64(May 1974):307–16.

[3.]Ibid., p. 308.

[4.]Ibid., p. 309.

[5.]John R. Hicks, The Theory of Wages, 2d ed. (London: Macmillan & Co., 1963), pp. 342–48.

[6.]Ibid.

[7.]John Bates Clark, The Distribution of Wealth (1899; reprinted., New York: Kelley & Millman, Inc., 1956), p. 117; Friedrich A. Hayek, The Pure Theory of Capital (London: Routledge & Kegan Paul, 1941), p. 93; George J. Stigler, Production and Distribution Theories: The Formative Period (New York: Macmillan Co., 1941), pp. 308–10.

[8.]See Frank H. Knight, “Capital, Time, and the Interest Rate,” Economica 1(August 1934):259; idem, “The Theory of Investment Once More: Mr. Boulding and the Austrians,” Quarterly Journal of Economics 50 (November 1935):57; and idem, “The Ricardian Theory of Production and Distribution,” in On the History and Method of Economics, ed. Frank H. Knight (Chicago: University of Chicago Press, 1956), p. 47; see also Hayek, Pure Theory, pp. 93–94.

[9.]Eugen von böhm-Bawerk, Positive Theory of capital, vol. 2, Capital and Interest,trans. George D.Huncke and Hans F. Sennholz(South Holland, Ill.: Libertarian Press, 1959), pp. 60–66, 282; see also Israel M. Kirzner, An Essay on capital (New York: Augustus M. Kelley, 1966),p.123.

[10.]See particularly Friedrich A. Hayek, “The Mythology of Capital,” Quarterly Journal of Economics 50(February 1936): 199–228.

[11.]Hicks, “Capital Controversies,” p. 309.

[12.]Ibid., p. 315.

[13.]This refers to the 1973 rather than the 1963 classification that Hicks presented.

[14.]Hicks, Theory of Wages, p. 343.

[15.]See, for example, Robert Dorfman, “A Graphical Exposition of Böhm-Bawerk’s Interest Theory,” Review of Economic Studies 26(February 1959):153–58; Kirzner, Essay on Capital, pp. 84–86.

[16.]See Frank A. Fetter’s remarks in “The ‘Roundabout Process’ in the Interest Theory,” Quarterly Journal of Economics 17(November 1902):177.

[17.]Hayek, “Mythology,” pp. 204–10; idem, Pure Theory, pp. 93, 146–53, 189–92.

[18.]Ludwig von Mises, Human Action: A Treatise on Economics (New Haven: Yale University Press, 1949), p. 264; for Mises’s views on capital and interest, see Israel M. Kirzner, “Ludwig von Mises and the Theory of Capital and Interest,” in The Economics of Ludwig von Mises: Toward a Critical Reappraisal, ed. Laurence S. Moss (Kansas City: Sheed & Ward, 1976).

[19.]See Kirzner, Essay on Capital, pp. 103–41.

[20.]Mises, Human Action, pp. 495–99, 611.

[1.]John Hicks, Capital and Time; A Neo-Austrian Theory (Oxford: Clarendon Press, 1973), p. 12.

[2.]Joseph A. Schumpeter, A History of Economic Analysis (New York: Oxford University Press, 1954), p. 847.

[3.]Paul A. Samuelson, “A Summing Up,” Quarterly Journal of Economics 80(November 1966):568–83.

[4.]Hicks, Capital and Time, p. 45.

[5.]Carl Menger, “Zur Theorie des Kapitals,” in The Collected Works of Carl Menger, ed. Friedrich A. Hayek, 4 vols.(London: London School of Economics, 1936)3: 135–83.

[6.]Hicks, Capital and Time, p. 12.

[7.]Ibid., p. 184.

[8.]L. L. Pasinetti, “Switches of Technique and the ‘Rate of Return,’” Economic Journal 79(September 1969):523.

[1.]“An equilibrium path, let us remember, is a path that will (and can) be followed if expectations are appropriate to it, and if the initial capital stock is appropriate to it; both conditions are necessary” (John Hicks, Capital and Growth [Oxford: Oxford University Press, 1965], p. 116).

[2.]John Maynard Keynes, The General Theory of Employment, Interest, and Money (New York: Harcourt, Brace & World, 1936), pp. 66–73.

[3.]Douglas C. Hague, “Summary Record of the Debate,” in The Theory of Capital, ed. F. A. Lutz and D. C. Hague (London: Macmillan & Co., 1961), pp. 305–6.

[1.]Ludwig von Mises, Theorie des Geldes und der Umlaufsmittel (1912); see the third English edition, The Theory of Money and Credit (New Haven: Yale University Press, 1953).

[2.]On the changes in relative prices attendant on an increase in the money supply, see Mises, Theory of Money and Credit, pp. 139–45.

[3.]For more on the fallacies of measurement and index numbers, see Mises, Theory of Money and Credit, pp. 187–94; idem, Human Action: A Treatise on Economics (New Haven: Yale University Press, 1949), pp. 221–24; Murray N. Rothbard, Man, Economy, and State (Princeton: D. Van Nostrand, 1962), 2:737–40; Bassett Jones, Horses and Apples: A Study of Index Numbers (New York: John Day & Co., 1934); and Oskar Morgenstern, On the Accuracy of Economic Observations 2d ed. rev. (Princeton: Princeton University Press, 1963).

[4.]See Mises, Theory of Money and Credit, pp. 170–78.

[5.]Chi-Yuen Wu, An Outline of International Price Theories (London: George Routledge & Sons, 1939), p. 126.

[6.]Wu, Outline, p. 284; Mises, Theory of Money and Credit, p. 178. Mises’s development of the theory was independent of Senior’s because the latter was only published in 1928 in Industrial Efficiency and Social Economy (New York, 1928), pp. 55–56; see Wu, Outline, p. 127 n.

[7.]Wu, Outline, p. 250; Mises’s formulation is in Theory of Money and Credit, pp. 179–88.

[8.]See Wu, Outline, pp. 251–60.

[9.]Mises’s regression theorem may be found in Theory of Money and Credit, pp. 97–123. For an explanation and a diagrammatic representation of the regression theorem, see Rothbard, Man, Economy, and State, pp. 231–37. Menger’s insight into the origin of money on the market may be found in Carl Menger, Principles of Economics (Glencoe, Ill.: Free Press, 1950), pp. 257–62. On the relationship between Menger’s approach and the regression theorem, see Mises, Human Action, pp. 402–4.

[10.]Mises, Human Action, pp. 405–7. The regression analysis was either adopted by or arrived at independently by William A. Scott in Money and Banking, 6th ed. (New York: Henry Holt & Co., 1926), pp. 54–55.

[11.]J. C. Gilbert, “The Demand for Money: The Development of an Economic Concept,” Journal of Political Economy 61(April 1953):149.

[12.]Don Patinkin, Money, Interest, and Prices (Evanston, Ill.: Row, Peterson & Co., 1956), pp. 71–72, 414.

[13.]Paul A. Samuelson, Foundations of Economic Analysis (Cambridge: Harvard University Press, 1947), pp. 117–18.

[14.]George J. Stigler, Production and Distribution Theories: The Formative Period (New York: Macmillan Co., 1946), p. 181; also see the similar, if more polite, attack on Menger by Frank H. Knight, “Introduction,” in Menger, Principles, p. 23. For a contrasting discussion by the mathematical economist son of Menger, Karl Menger, see “Austrian Marginalism and Mathematical Economics,” in Carl Menger and the Austrian School of Economics, ed. John R. Hicks and Wilhelm Weber (Oxford: Clarendon Press, 1973), pp. 54–60.

[15.]Mises, Human Action, p. 250.

[16.]Ibid., pp. 249–50, 414.

[17.]F. H. Hahn, “On Some Problems of Proving the Existence of an Equilibrium in a Monetary Economy,” in The Theory of Interest Rates, ed. F. H. Hahn and F. P. R. Breckling (London: Macmillan & Co., 1965), pp. 128–32.

[18.]Mises, Human Action, p. 418.

[19.]On the advantages of a secularly falling price “level,” see C. A. Phillips, T. F. McManus, and R. W. Nelson, Banking and the Business Cycle (New York: Macmillan Co., 1937), pp. 186–88, 203–7.

[20.]Costantino Bresciani-Turroni, The Economics of Inflation (London: George Allen & Unwin, 1937), pp. 80–82; also see Frank D. Graham, Exchange, Prices, and Production in Hyper-inflation: Germany 1920–23 (New York: Russell & Russell, 1930), pp. 104–7. For an analysis of hyperinflation, see Mises, Theory of Money and Credit, pp. 227–30; and idem, Human Action, pp. 423–25.

[21.]Rudolf Havenstein, Address to the Executive Committee of the Reichsbank, 25 August 1923, translated in Fritz K. Ringer, ed., The German Inflation of 1923 (New York: Oxford University Press, 1969), p. 96.

[22.]See Denis S. Karnofsky, “Real Money Balances: A Misleading Indicator of Monetary Actions,” Federal Reserve Bank of St. Louis Review 56(February 1974):2–10.

[23.]market price of approximatelyTheory of Money and Credit, pp. 448–57; also see Michael A. Heilperin, Aspects of the Pathology of Money (Geneva: Michael Joseph, 1968); and Jacques Rueff, The Monetary Sin of the West (New York: Macmillan Co., 1972).

[24.]See Mises, Human Action, pp. 431–45.

[25.]Leland B. Yeager, “Essential Properties of the Medium of Exchange,” Kyklos (1968), reprinted in Monetary Theory, ed. R. W. Clower (London: Penguin Books, 1969), p. 38.

[1.]John B. Egger, “Information and Unemployment in the Trade Cycle” (Paper delivered at Second Symposium on Austrian Economics, University of Hartford, June 1975), p. 16.

[2.]The eleven countries are: Belgium, Canada, France, Israel, Japan, Netherlands, Sweden, Switzerland, United Kingdom, United States, and West Germany. For data supporting the statements in the text, see Arthur Seldon, ed., Inflation: Economy and Society (London: Institute of Economic Affairs, 1972), Appendix.

[3.]See, for example, United Nations, Economic Commission for Europe, Economic Survey of Europe in 1961: Some Factors in Economic Growth in Europe during the 1950’s (E/ECE/452/Add. 1) (Geneva 1954), pp. 23–32; Great Britain, Council on Prices, Productivity, and Incomes, Fourth Report (HMSO 1961); Great Britain, National Economic Development Council, Conditions Favourable to Faster Growth (HMSO April 1963); Great Britain, National Economic Development Council, Growth in the U.K. Economy to 1966 (HMSO February 1963); Political and Economic Planning, Growth in the British Economy (London: Allen & Unwin, 1960), pp. 1–53, 197–219; Angus Maddison, Economic Growth in the West: Comparative Experience in Europe and North America (London: Allen & Unwin, 1964).

[4.]Organization for Economic Cooperation and Development, OECD Economic Outlook, 14(December 1973):32; ibid., 15(July 1974):18.

[5.]See tables referred to in note 2; also see Organization for Economic Cooperation and Development, OECD Economic Outlook 15(July 1974):73–77; and almost any issue of The Economist, e. g., “To Meet Slumpflation” and “Mass Unemployment Ahead?” The Economist 250(23 March 1974):14–16; “Before Taking to Wheelbarrows,” The Economist 252(20 July 1974):65–66; see also the report from Peter Jay, “OECD forecasts increased inflation in Britain for first half of next year; Reflation ‘would make matters worse,’” Times (London), 3 October 1974, p. 1; and National Institute of Economic and Social Research, National Institute Economic Review 69(August 1974):4–26.

[6.]J.C.R. Dow, The Management of the British Economy, 1945–60 (Cambridge: Cambridge University Press, 1964), chap. 13; L.A. Dicks-Mireaux, Cost or Demand Inflation? Woolwich Economic Papers, no. 6 (London, 1965).

[7.]Nicholas Kaldor, “The New Monetarism,” Lloyd’s Bank Review, no. 97 (July 1970), pp. 1–17.

[8.]Ibid.; see also Joan Mitchell, “Why We Need an Incomes Policy,” Lloyd’s Bank Review, no. 92 (April 1969), pp. 1–14.

[9.]This view is shared by several Austrians as well; see Ludwig M. Lachmann, Macroeconomic Thinking and the Market Economy, Institute of Economic Affairs, Hobart Paper no. 56 (London, 1973), p. 50.

[10.]For an indirect demonstration that the existence of money makes sense only in a multicommodity world and that a multicommodity world is virtually inconceivable in the absence of a medium of exchange, see Carl Menger, Principles of Economics (Glencoe, Ill.: Free Press, 1950), pp. 236–85. It should be pointed out that in the more sophisticated versions of the Keynesian analysis, changes in interest rates do affect the prices of investment goods relative to the prices of consumer goods. See the extensive discussions of aggregation in Axel Leijonhufvud, On Keynesian Economics and the Economics of Keynes (New York: Oxford University Press, 1969), pp.20–23, 111–85.

[11.]“The aspect of Keynes’ theory which has created the most trouble . . . is his theory of interest—which is rather a theory of short-run interest movements“ (Leijonhufvud, Keynesian Economics, pp. 12–13). We maintain that modern Keynesian writers have still not solved this problem.

[12.]D. H. Robertson, “Mr. Keynes and the Rate of Interest,” in Essays in Monetary Theory, ed. idem (London: P. S. King & Son, 1940), p. 25.

[13.]See Charles W. Baird, Macroeconomics (Chicago: Science Research Associates, 1973), for an example of a recent attempt to introduce price-level flexibility and to adopt a micro approach in macroanalysis. Attempts like this, though praiseworthy, have not been successful. Microanalysis deals with pricing and resource allocation and hence with the time structure of output and prices. Microeconomics is far more than the analysis of single prices in isolation. Manipulation of price levels would seem to have little to do with microanalysis in this sense.

[14.]The following analysis and interpretation of the monetarist position is based on Milton Friedman, “A Theoretical Framework for Monetary Analysis,” Journal of Political Economy 78(March-April 1970):193–238; idem, “A Monetary Theory of Nominal Income,” Journal of Political Economy 79(March-April 1971): 323–37; idem, Dollars and Deficits (Englewood Cliffs, N. J.; Prentice-Hall, 1969).

[15.]John Stuart Mill, Principles of Political Economy, ed. Sir William Ashley (Clifton Heights, N. J.: Augustus M. Kelley, 1973), p. 491.

[16.]See Thomas Sowell, Classical Economics Reconsidered (Princeton: Princeton University Press, 1974), pp. 52–66.

[17.]Friedman admitted that he and Anna J. Schwartz “have little confidence in [their] knowledge of the transmission mechanism, except in such broad and vague terms as to constitute little more than an impressionistic representation rather than an engineering blueprint” (The Optimum Quantity of Money [Chicago: Aldine Publishing Co., 1969], p. 222).

[18.]Ludwig von Mises, The Theory of Money and Credit (New Haven: Yale University Press, 1953), pp. 124–31.

[19.]Friedman, “Theoretical Framework,” p. 223.

[20.]Milton Friedman, Dollars and Deficits, pp. 72–96.

[21.]See Trygve Haavelmo, “What Can Static Equilibrium Models Tell Us?” Economic Inquiry 12(March 1974):27–34.

[22.]See, for example, “The Rising Risk of Recession,” Time Magazine, 19 December 1969, pp. 66–72.

[23.]Friedrich A. Hayek, The Pure Theory of Capital (London: Routledge & Kegan Paul, 1941), pp. 409–10.

[24.]F. H. Hahn, “On Some Problems of Proving the Existence of an Equilibrium in a Monetary Economy,” in The Theory of Interest Rates, ed. F. H. Hahn and F. P. R. Beckling (London: Macmillan & Co., 1965), pp. 128–32.

[25.]Menger, Principles, pp. 236–85.

[26.]Knut Wicksell, Lectures on Political Economy, ed. Lionel Robbins, 2 vols. (New York: Macmillan Co., 1935) 2:141–90.

[27.]For an appreciation of Mises’s contributions to the development of monetary theory, see Laurence S. Moss, “The Monetary Economics of Ludwig von Mises,” in The Economics of Ludwig von Mises: Toward a Critical Reappraisal, ed. Laurence S. Moss (Kansas City: Sheed & Ward, 1976).

[28.]Hayek first presented his monetary analysis of the business cycle to the English-speaking world in four lectures at London University in 1931; see Friedrich A. Hayek, Prices and Production (London: Routledge & Kegan Paul, 1935). His earlier German work on monetary theory was translated and published in 1933; idem, Monetary Theory and the Trade Cycle (New York: Augustus M. Kelley, 1966). In 1939 Hayek developed his theory further in an essay entitled “Profits, Interest, and Investment,” which he published along with some of his earlier articles under the same title; see idem, Profits Interest and Investment (New York: Augustus M. Kelley, 1970); see also idem, “Three Elucidations of the Ricardo Effect,” Journal of Political Economy 77 (March-April 1969):274–85.

[29.]Ibid., p. 281.

[30.]Hayek, Prices and Production.

[31.]Ludwig M. Lachmann, Capital and Its Structure (London: London School of Economics, 1956).

[32.]Two types of complementarity exist: “horizontal complementarity,” where goods in any one stage of production must be integrated, and “vertical complementarity,” where goods must be integrated between stages.

[33.]Hayek referred to this effect as the “Ricardo effect.” For references to Hayek’s writings and further explanations, see Gerald P. O’Driscoll, Jr., “The Specialization Gap and the Ricardo Effect: Comment on Ferguson,” History of Political Economy 7(Summer 1975): 261–69.

[34.]The physical durability of a capital good is not the only determining factor in its demand price; also important is its position in the overall capital structure (Hayek, Pure Theory, pp. 46–49).

[35.]We are discussing changes in the real rate of interest; the nominal rate may vary owing, among other factors, to the impact of future price expectations.

[36.]Hayek, Pure Theory, pp. 33–34.

[37.]The view that the effects of monetary expansion are self-reversing meets with hostility; see, for example, Friedman, “Comments on the Critics,” Journal of Political Economy 80(September-October 1972): 936–41. It is ironic that, in his 1974 address to the Southern Economics Association in Atlanta, Friedman acknowledged that less unemployment now (caused by an unanticipated increase in the growth rate of the money supply) will result in more unemployment later; that is, cyclical expansions bring about cyclical contractions. While it is true that Friedman’s talk made no reference to real factors of the type discussed here, still it is an improvement over his earlier attitude where he refused to consider this form of reasoning at all.

[38.]See Hayek, “Three Elucidations,” pp. 284–85.

[39.]Even with “indexation,” however widespread, new money would still enter the economy at a specific point and first alter some relative prices and outputs before altering other prices and outputs. These misallocations and subsequent corrections would continue as long as the increase in the money supply persisted. Indexation of money payments would merely add yet another unpredictable relative price change to those already set in motion by the monetary disturbances. In particular, some incomes would continue to rise ahead of the consumer price index while others would rise after it. Indexation would only allow for (known) past changes in the consumer price index resulting from those increases in the money supply that had already worked through the economy. It could do little ex ante about present increases in the money supply still working their way through the economy. The case for indexation is made by a number of economists; see especially Milton Friedman, Monetary Correction (London: Institute of Economic Affairs, 1974).

[40.]Hayek, Profits, Interest, and Investment, pp. 63 n, 64 n.

[41.]Friedman, Dollars and Deficits, pp. 72–96.

[42.]Paul W. McCracken, “Are the Latter Days Upon Us?” Wall Street Journal, 22 July 1974, p. 8.

[43.]Harry G. Johnson, “Mercantilism, Past, Present and Future,” Manchester School 42(March 1974):15.

[44.]Gottfried Haberler, Prosperity and Depression, 5th ed. (London: Allen & Unwin, 1964), pp. viii, xi.

[45.]The general council of the U.K. Trades Union Congress demanded government subsidies for all firms threated with losses and therefore having to lay off workers; see the report by John Elliott, “TUC urges more government control over redundancies,” Financial Times (London), 24 October 1974, p. 1.

[46.]Thus aggregate money expenditure rose by 248 percent in the United Kingdom between 1949 and 1969, but output rose only 69 percent. Similar money increases may be adduced for other developed countries. Nevertheless, Denis Healey, chancellor of the exchequer, found it necessary to issue a warning to the 1974 Conference of the International Monetary Fund not to repeat “the tragedy of the 1930’s [by attempting] to deal with inflation by measures likely to produce mass unemployment”; see the report entitled “Mr. Healey warns the world on threat of 1930’s tragedy being repeated,” and the report from Peter Jay, “Chancellor emphasizes need to avoid mass unemployment,” The Times (London), 2 October 1974, p. 1.

[47.]Paul A. Samuelson, “Worldwide Stagflation,” Morgan Guaranty Survey, June 1974, pp. 4–9.

[48.]From Hayek’s remarks at the Mont Pelerin Conference, Caracas, September 1969; these remarks are on record only in Friedrich A. Hayek, A Tiger by The Tail, ed. Sudha R. Shenoy, Institute of Economic Affairs, Hobart Paper no. 4 (London, 1972), p. 112.

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PART 3: APPLICATIONS - Edwin G. Dolan, The Foundations of Modern Austrian Economics [1976]

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PART 3

APPLICATIONS

Equilibrium versus Market Process

EQUILIBRIUM AND PROCESS

ROBBINSIAN ALLOCATION AND MISESIAN ACTION

THE ROLE OF ENTREPRENEURSHIP

ADVERTISING AS AN ASPECT OF THE COMPETITIVE PROCESS

PROFITS AND THE COMPETITIVE PROCESS

NOTES

On the Central Concept of Austrian Economics: Market Process

NOTES

The Theory of Capital

HICKS, MATERIALISTS, AND FUNDISTS

FUNDISTS: A TERMINOLOGICAL PUZZLE

HICKSIAN FUNDISM

AUSTRIANS, MATERIALISTS, AND FUNDISTS

ON MEASURING CAPITAL: THE INDIVIDUAL

MEASURING CAPITAL: THE ECONOMY

ON THE NOTION OF THE QUANTITY OF CAPITAL PER HEAD

NOTES

On Austrian Capital Theory

NOTES

Toward a Critique of Macroeconomics

NOTES

The Austrian Theory of Money

NOTES

Inflation, Recession, and Stagflation

I

THE KEYNESIAN DIAGNOSIS

THE MONETARIST POSITION14

II

MONETARY EXPANSION, PRICING, AND RESOURCE ALLOCATION

MONETARY EXPANSION AND THE PRODUCTION STRUCTURE

THE SELF-REVERSIBILITY OF MONETARY CHANGES

PRICE EXPECTATIONS AND RESOURCE ALLOCATION

THE INADEQUACIES OF A PURELY MONETARY APPROACH

STAGFLATION AND MONETARY ACCELERATION

NOTES