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Econ 4730

Dr. Quinn




Capital Structure and the
Animal Spirits
Austrian versus Keynesian Business Cycle Theory
Alex Benson




                                             12/8/10
1




                                              Introduction
        Following the stock market crash in October of 1929, the United States was thrown into an
economic Depression. The longevity and severity of which was unparalleled in modern capitalist
society. This “Great Depression” as it was called seemed to obliterate the conventional (Classical)
economic wisdom of the time; and out of this theoretical wreckage two economic schools of
thought rose to prominence: Austrian and Keynesian. The Austrians had existed as a heterodox
school since the late 19th century, but the Keynesians came in to being as a school of economic
thought in response to the Great Depression. While the two schools offered compelling
explanations for the catalyst of the recent crash, the explanations themselves could not have been
more different.
        The Austrians School argued that the Depression had been caused by artificially low interest
rates set by the central bank, which led to excessive credit creation and mal investment. They
believed that when the central bank held interest rates too low for too long, massive inflationary
bubbles in investment due to credit creation coincided with artificially low saving; thus a speculative
bubble which must inevitably collapse was created. Contrarily, Keynes argued that the Depression
was the result of an unemployment equilibrium created by insufficient aggregate demand for goods
and services. Keynes argued that such a general glut was possible and therefore rejected the
Classical belief in Say’s Law.
        The following paper will examine the Austrian theory of the Business Cycle as well as the
methodology upon which its theory is founded. Interwoven in the following analysis and contrasting
the Austrian approach will be examinations of the Austrians chief rival: the Keynesian School. Each
school’s arguments will be presented, along with the other’s critiques. However, before an in depth
discussion of each school’s competing business cycle theories can be presented, an analysis of their
foundations and applicable methodology is required.


                                              Methodology
                  Austrian Economics retains the deductive, logical method of its founder, Karl
Menger. Whereas the Neoclassical, Keynesian, and other more mainstream schools have adopted
intensely mathematical techniques for working through highly aggregated models, the Austrians
prefer to view economics as an a priori science. As an a priori science, economics and its
2




propositions are to be justified through rigorous, logical deduction. Mathematics is carried out using
various statistics and combining them in different ways so as to produce a product, quotient, sum,
difference etc. According to the Austrians it is this quasi definition of mathematics that makes its
use so objectionable for use in pure economic study. Economic statistics are by definition products
of past economic history. Therefore relying on mathematical manipulations of these statistics is
synonymous with a reliance on economic history and experience as a means of study of catallactics.
Austrians argue that this usage of mathematics as a means of studying economics transforms the
science from a qualitative one into a quantitative one; A quantitative science where econometric
models and aggregated variables are seen as superior to a priori deduction1. Murray Rothbard, a
giant in the post-Mises Austrian tradition put it best: “Gazing at sheaves of statistics without
prejudgment is futile”2.
        To the Austrians, the highly aggregated and mathematical models of the more mainstream
schools oversimplify the complex decisions made in the interplay between consumers and
producers. This process of merging all economic decision making into one equation or graphical
display is, according to the Austrians, implicitly fallacious because it ignores the heterogeneity of
the individual actors in the economy. The Austrians believe that such absolute aggregation ignores
the dynamism and ability to quickly restructure markets retained by most important player in any
economy: the entrepreneur.
        Austrians include the science of economics—as most other schools do in one fashion or
another—in a broader and more general science of human choice; a science which is exemplified by
this deductive process; and a science which Ludwig von Mises called “Praxeology”. Mises explained
Praxeology in this way:
        Its statements and propositions are not derived from experience. They are, like those of logic and
        mathematics, a priori. They are not subject to verification and falsification on the ground of
        experience and facts. They are both logically and temporally antecedent to any comprehension of
        historical facts. They are a necessary requirement of any intellectual grasp of historical events3.
As evidenced, Austrians argue against reliance on observed empirical relationships or evidentiary
fact as a means of developing economic theory; at least as the primary means of doing so. Evidence
to the Austrians can be misleading.
3




        In addition to preserving the less formalized and more deductive methodology of earlier
generations of economists, the Austrians maintain the Classical adherence to Say’s Law. Put simply,
Say’s Law provides that supply creates its own demand. Therefore, there can never be a general
glut in demand for goods and services. Obviously, a critique of this declaration would include the
assertion that the very presence of an economic recession disproves Say’s law. Since recessions are
famous for their ubiquity, it should follow that Say’s law is nothing more than another fallacy of a
Classical Economics which excessively concerned itself with growth theory and insufficiently with
the trade cycle. Indeed it was Keynes himself, the theoretical converse of the Austrian School, who
famously claimed to have disproved Say’s Law in His General Theory. There, Keynes quotes the
beginning of a passage on Say’s Law written by John Stuart Mill, in which Mill writes that “What
constitutes the means of payment for commodities is simply commodities” and that “could we
suddenly double the productive powers of the country… Everybody would be able to buy twice as
much because everyone would have twice as much to offer in exchange”4.
        It is the above formulation of Say’s Law that Keynes refutes. In so doing, he makes the case
for government stimulus, either fiscal or monetary; to correct for the gluts that must result
provided that Say was wrong. Keynes argues not only that markets, under a complete laissez-faire
environment, trend towards overproduction and recession; he argues that such conditions are the
norm and that equilibrium can exist at various different levels below full employment. Keynes
postulates that: “…the evidence indicates that full, or even approximately full, employment is of
rare and short lived occurrence”5 (something both schools, in a sense, agree on). Keynes offers a
more theoretical defense of this hypothesis by qualifying the demand for money as determined by
income and the interest rate—something the Classical Quantity Theory of Money leaves out.
        The real interest rate for Keynes is equal to the nominal rate minus the expected rate of
inflation; and if this difference is larger than expected deflation, then excessive saving and a general
glut (deflation) result. This result, along with a removed and illogical spontaneous optimism which
according to Keynes drives much of our positive activities—what Keynes calls the “animal spirits”—
work to get the economy into an unemployment equilibrium from which it cannot escape through
traditional market forces. Keynes described the Animal Spirits in this way:
        Most, probably, of our decisions to do something positive, the full consequences of which will be
        drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous
4



        urge to action rather than inaction, and not as the outcome of a weighted average of quantitative
        benefits multiplied by quantitative probabilities6.
        The Austrians, in contrast, offer a defense of Say’s Law. They would point out that Keynes
only quoted a fraction of Mill’s statement regarding Say’s Law. The sentences following Keynes’
quotation offer the conditions by which Say’s Law holds. Mill continues by writing that:
        If we doubled the productive powers of the country, we should not double the supply of
        commodities in every market, and if we did we should not clear the markets of the double supply in
        every market… Although the Community would willingly double its aggregate consumption, it may
        already have as much as it desires of some commodities, and it may prefer to more than double its
        consumption of others… If so, the supply will adapt itself accordingly, and the values of things will
        continue to conform to their cost of production”7
This lengthy and somewhat haphazard quotation of Mill is necessary to adequately emphasize the
Austrian against the Keynesian view of Say’s Law. The Austrians do not adhere to any belief that
there cannot be a relative glut in the economy, nor that specific industries cannot experience a glut
corresponding to overproduction in others. The Austrians merely adhere to a formulation of Say’s
Law which provides that there can never be a general overproduction of all goods and services8.
        In reference to Keynes’ point on interest rate determined excesses of saving or investment,
Austrians draw the following conclusions. The Austrians disagree with the causal relationship
between inflation/deflation and saving/investment posited by Keynes. To the Austrians, it is
because of new money and bank credit being created through low interest rates that investment
can exceed savings; thus investment exceeds genuine savings because we are in a period of
inflation. In the period of liquidation that follows the inflation, it is because bank loans are being
repaid and not renewed and the money supply is shrinking that savings exceeds investment: savings
exceeds investment because we are in a deflation. Austrians argue that at any one time there is
always equality between savings and investment, but there can be “an inequality between prior
saving and subsequent investment”. This inequality between saving and investment is the
consequence and not the cause of the inflation/deflation being experienced in an economy9.
        While the Austrians do adhere to a the aforementioned, specific formulation of Say’s Law,
they do not share other Neo-Classical beliefs—perhaps better described as assumptions—such as
perfectly competitive markets and market equilibrium. Austrians assert that market equilibrium
5




where supply and demand intersect, at one market clearing price, is a fantasy. They supplant this
view with the more precise formulation of a dynamic marketplace characterized and driven by a
perpetual search for and employment of information. By definition such a characterization of the
marketplace assumes imperfect information: another bulwark of the Austrian methodological
construct. An absence of perfect information in any economy leads to widespread market
ignorance and thus disequilibrium. It is this disequilibrium that is responsible for profit
opportunities. The Entrepreneur exploits these opportunities, and in so doing he converts
underutilized resources into a more productive capacity. Thus, to the Austrians, the entrepreneur is
the most important participant in any economy and the primary driver of economic growth10.
        The Austrian School’s conceptualization of the capital stock, and interest rates, are the final
methodological constructs which must be examined prior to an assessment of the Austrian Business
Cycle Theory proper. The Austrians view capital as heterogeneous; meaning that different capital
goods are specific to different stages of production, though some capital goods can be shifted
between orders of production; in effect varying “the temporal relationship between labor input and
consumable output”11. A varying of the “temporal relationship between labor input and
consumable output” refers to the fact that shifts can occur in the capital structure as it expands or
contracts depending on the time preferences of those in the economy. If time preferences shift
towards saving more in the present to consume more in the future, the structure of production
expands temporally and more capital goods versus consumer goods are produced. Capital (higher
order) goods take more time in their production. During the expanded time period needed for the
production of higher order capital, capital which can be shifted does so. Interest, like all other prices
in the Austrian framework, is determined subjectively. Austrians assert that the interest rate is
determined by the differing time preferences of borrowers and lenders in the economy: time
preferences referring to the preference of a current good over a future good (the discounting of
future relative to current consumption)12. The relationship between the interest rate, the capital
stock, and the money supply is central to the Austrian Theory of the Business Cycle and will be
explained more in depth later.
        In sum, the Austrian’s propose that while the relevant facts and economic data under
scrutiny may relate perfectly with a proposed catallactic theory, the relationship itself may be
spurious because of some unknown variable. Since it would be impossible to know the spuriousness
6




of a catallactic relationship, only rigorously logical deduction flowing from a priori truths should be
used as a means of economic study. It is the process of logical deduction which should guide an
economist’s understanding of empirical evidence and statistics. The Austrians adhere to a specific
formulation of Say’s Law which does not rule out slumps entirely, merely a general slump affecting
every sector of the economy. Finally, the Austrians argue that due to imperfect information,
dynamism and change, not equilibrium, exemplify the market. This method of characterizing the
economy forms the basis of the Austrians vehement opposition to government involvement in the
market process.
        Keynesian methodology in numerous ways represents the antithesis of that of the
Austrians. Accordingly, a juxtaposition of the two schools methodologies helps to explain why, in
many ways, their business cycle theories seem to contradict one another. Now that juxtaposition
has been offered, we can delve into that even more controversial and applicable argument dividing
the two schools of thought: their competing theories of the business cycle.


                                          Business Cycle Theory
        John Maynard Keynes once famously wrote that “The long run is a misleading guide to
current affairs. In the long run we are all dead… Economists set themselves too easy, too useless a
task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat
again”13; Keynes was right. He was right in the sense that economists must integrate their studies of
the long and the short run (growth and business cycles) if they are to adequately construct a
working theory of general economics. Economists who merely trumpet the belief that eventually
markets will clear and the “storm” will pass, without a general theory of why the storm came to be
in the first place, are in contempt of economics itself. Catallactics requires such integration if it is to
be in any way applicable to the real world. The Austrians and Keynesians briefly agree on this point.
However their specific diagnoses of and prescriptions for cycle fluctuations drastically deviate from
one another. It is to this competing analysis that we now turn.
        The Keynesian School’s explanation of the business cycle has become a dominant theory in
the economics profession. The concept that recessions are caused by a fall off in aggregate demand,
leading to a vicious deflationary cycle, is by far the primary theory taught in the contemporary
macroeconomics classroom. Because of his theory’s immense popularity, Keynes’ theory of the
7




business cycle will not be outlined in detail. Instead, Keynes’ theories will be mentioned to the
extent that they counter the proposals of the Austrian School.
       Austrian Business Cycle Theory focuses on the role of money and entrepreneurs in the
economy. The Austrians seek to explain why, after prolonged periods of astute investment and
forecasting decisions, the economy’s entrepreneurs suddenly suffer losses. Put differently: “why is
there a sudden general cluster of business errors?”14 The Austrians adhere to the following,
admittedly self-evident, formulation of entrepreneurs’ activities: better entrepreneurs, who more
successfully forecast investor and consumer demand, make profits; while unsuccessful
entrepreneurs suffer losses. In this fashion the market weeds out the less successful entrepreneurs.
The Austrians then, through their business cycle theory, are attempting to explain why, if the
process occurs as described, large numbers of tested and efficient entrepreneurs suddenly make
bad investments and suffer general losses.
       The Austrians explanation of this cluster of errors, commonly referred to as the business
cycle or the “Boom and Bust”, focuses on the role of money in an economy and its ability to distort
time preferences and the capital structure. The Austrians argue that in a free market, there can
never be a cluster of errors, because all entrepreneurs will not be making mistakes at the same
time. To the Austrians, artificial credit expansion to businesses, carried out by banks but always
enabled by a central bank and implicit moral hazard, causes such a cluster of errors by facilitating
bad investments. These bad investments propagate alongside the artificial credit expansion until
the inevitable contraction of the “loose money” strategy; which leads to an eventual bust.
       In his book America’s Great Depression, Austrian economist Murray Rothbard makes the
argument for Austrian Business Cycle Theory (ABCT) by first asking the reader to consider the
mechanics of an economy with a fixed money supply. In such an economy, some money is spent on
consumption while the rest is saved and then invested into a structure of capital with various orders
of production. The determining factor of the proportion of consumption to saving is people’s time
preferences, or, “the degree to which they prefer present to future satisfactions”15. The less that is
preferred in the present, the lower the time preferences will be, and thus the lower the pure
interest rate will be (as it is determined by people’s time preferences). Therefore consumption is
foregone in the present in order to pursue more goods in the future. The greater the gap between
preferred investment and current consumption, the longer the structure of production: the building
8




up of capital; will be. To the Austrians, the final market interest rate is equal to the pure interest
rate plus or minus two components: entrepreneurial risk and purchasing power of the economy’s
money. This leads to a dynamic structure of interest rates rather than one uniform rate. The
structure of interest rates is majorly determined by the pure interest rate; which in turn is first
made manifest in what Rothbard calls the natural interest rate: the going rate of profit reflected in
the interest rate in the loan market16. Now that we have established the workings of an economy
with a fixed money supply, we can explore what happens when new money is injected into the
economy. i
        When the central bank increases the amount of the money stock—whether in the form of
currency or deposits—the interest rate decreases as it appears that vast amounts of new savings
are available as funds for investment. Businesses are tricked by the inflation into thinking that
saving (as determined by time preferences) has increased, and invest in longer processes of
production. Investing in longer processes of production is synonymous with lengthening the capital
structure: i.e. higher order or, capital, goods are produced instead of lower order consumption
goods more associated with consumers17. None of these effects would necessarily be detrimental to
the economy so long as real time preferences expanded alongside the increase in “saving”.
However this is not the case as the increase in “saving” was merely an illusion created by the
increase in the money supply by the central bank.
        The new credit eventually finds its way down to the factors of production: mainly and for
the sake of this argument, in the form of wages to workers. The workers will of course look for
places to spend their new incomes; as the original preferences for saving and consumption have not
changed. Workers do not in general purchase higher order (capital) goods, and since time
preferences have not changed, they will look to spend their incomes in the same proportions as
before. In this scenario, a general oversupply of capital goods exists and businesses will begin to
shift their structure of production back towards the old proportions (assuming no government
interference). A common argument of the Keynesian School is that recessions are brought on by
underconsumption: i.e. overproduction. The Austrians, in one of the great ironies of economics,
agree; at least somewhat. To the Austrians, overproduction occurs in the capital goods industries
where entrepreneurial demand for higher order goods does not keep pace with excess supply
driven by credit expansion. Real demand for higher ordered goods does not increase at all in fact
9




because real time preferences have not changed. In order to move towards profits once again,
businesses shift their production back towards lower order goods and away from the higher order
goods industries that have been booming. At this point we observe a bust in the previously hyper-
expanding higher order industries leading to mass unemployment in those particular sectors.
        The proper economic policy prescription to deal with general business cycles brought on in
this way is to allow for liquidation. Allowing bad investments to fail will eventually bring the interest
rate and thus the structure of production back into coordination with consumers’ time preferences.
Liquidation does not occur, the Austrians argue, because central banks do not immediately cease
their expansion of the money supply. Perpetuation of a loose money policy can “keep the
borrowers one step ahead of consumer retribution”18. Additionally, fiscal policy, while not creating
the original misallocation of resources, can pervert and slow the market’s recovery by preventing
liquidation of the debt and mal-investment catalyzed by this misallocation. If banks and other
businesses are considered too big to fail and are saved from bankruptcy, then no progress has been
made. Instead, these companies are free to pursue the same mistaken policies as before and
investment in the economy is not reallocated to conform to consumers’ real time preferences. If
liquidation is prevented, then the boom and bust cycle is perpetuated.
        Thus we have a complete theory of the business cycle. The central bank expands credit
which banks then lend to borrowers as if backed by real saving, though consumers’ time
preferences have not changed. This leads to malinvestment in higher order goods which are not
demanded by consumers. When malinvestment becomes evident, the inflationary boom ceases and
liquidation is necessary to bring consumers’ time preferences and the capital structure of
production back into coordination. This liquidation is the depression stage of the business cycle, as
liquidation and realignment of investments necessarily will lead to unemployment. Once old
investments have been eliminated, the jobs lost can begin to come back as employment
opportunities reemerge in free market determined investment. Therefore the Austrians believe
that the boom is the period to be leery of. For it is during the boom that cheap credit perverts
investment towards higher order goods in a cycle only halted by monetary restraint and liquidation.
        Obviously many of the tenants of (ABCT) contradict those of its Keynesian rival. While the
Austrians assert that credit creation by the central bank creates the boom and bust cycle, the
Keynesians would argue that expansionary monetary policy is a necessary and primary means of
10




escaping from unemployment equilibrium (recession) brought on by an imperfect market
mechanism. The differing views of the two schools can be attributed mainly to their differing
methodology, as described previously. Whereas the Keynesians would view the economy as tending
toward unemployment equilibrium due to irrational speculation and the animal spirits, the
Austrians would assert that dynamic entrepreneurial profit seeking will keep the economy growing
and trending towards full employment (though full employment equilibrium is never achieved in
the Austrian Model). Both schools’ theories contain their respective merits, and the two theories
represent the two most intellectually rigorous and historically pragmatic visions of the business
cycle. In order to better understand the intricacies of (ABCT) against Keynesian theory, it is helpful
to study empirical evidence of historical recessions, and correlate evidence with theory.


                                        Analysis and Implications
        Any economic theory which purports to explain the business cycle must conform to some
amount of empirical evidence. Even the Austrians agree on this point. The Austrians agree that
empirics can help to validate an economic theory; they merely argue that empirics should not be
used as inputs in the formation of the theory itself. In that case, it is proper that the historical
record pertaining to the most recent “great recession” be examined to find evidence for the validity
of (ABCT).
        If we follow the logic of the business cycle laid out by the Austrian School, then we should
observe three primary events preceding the crash in December of 2007. First, we should observe a
significant increase in the money supply by the central bank (Federal Reserve). Second, and
following from this monetary increase, we should observe substantial booms in investment in
higher order, capital intensive industries such as construction. Third, we should observe a leveling
out or disinflation of the money supply immediately preceding the bust of the speculative bubble
propagated by the boom.
        Following the recession of 2001, and partly as a panicked reaction to the events of 9/11, the
Federal Reserve lowered its federal funds rate from 6.5% (May 2000) to 1% (2003)19. This
precipitated a drastic increase in the money supply following 2001—as shown in Table 1; allowing
for a drastic reduction in the cost of taking out loans and an expansion of the structure of
production, leading to increased longer term (higher order) investment. The most capital intensive
11




and therefore highest order industry, to the Austrians, is construction. It has been made apparent
by almost all schools of economics that the housing boom and bust contributed to or was a
consequence of the current recession: housing construction, as evidenced, is by definition a higher
order industry. The construction industry boomed following the 2001 recession only to be the
hardest hit industry after the recession in late 2007.
        Austrians formulate that the housing boom was a product of the slashing of the federal
funds rate and the increase in the money stock following the 2001 recession. As the structure of
production expanded due to increased credit availability, higher order goods boomed. However real
savings had not increased and therefore real preferences for higher goods among consumers had
not increased (Table 4). Therefore, the inevitable bursting of the artificial bubble in construction
occurred when the money supply leveled out around 2007 (see Table 1): artificial credit creation no
longer existed to the extent that it could perpetuate such malinvestment. Also, the construction
industry—an industry of the highest order—experienced the greatest percentage decrease in
employment of all capital intensive sectors (Table 5).
        The Austrians response to such a crisis as we are in now is to allow markets to liquidate bad
investment and reallocate the structure of production so as to conform to real savings. As for
reform, the Austrians would advocate for the institution of a strict gold standard as a metric for the
money supply; and therefore an abolition of the Federal Reserve. The Austrians argue that a strict
gold standard would not only make monetary expansion by the Federal Government nearly
impossible, it would also help to curtail bank money creation through the fractional reserve system.
These views obviously run counter to the Keynesian prescription of allowing for countercyclical
monetary and if necessary, fiscal policy as a means of combating recession. To Austrians, this
disagreement with Keynes is equivalent to a stamp of legitimacy. The Austrians view Keynesian
policy as perpetuating many past crises as well as the current one and therefore, Austrians would
argue; it is time for a change.
12




                  Table 1: Austrian Accepted Measures of the Money Supply




TMS is a formulation of the Money Supply created by Murray Rothbard; representing the amount of
money in the economy available for immediate use in exchange. TMS consists of the following:
Currency Component of M1, Total Checkable Deposits, Savings Deposits, U.S. Government Demand
Deposits and Note Balances, Demand Deposits Due to Foreign Commercial Banks, and Demand Deposits
Due to Foreign Official Institutions.
Source: Ludwig von Mises Institute
13




                        Table 2: Boom in Construction Employment




Source: St. Louis Federal Reserve

                                    Table 3: Real Estate Boom
14




                                   Table 4: Personal Savings Depreciation




Source: St. Louis Federal Reserve
                   Table 5: Measures of Percentage Decrease in Ordered Industries




The most capital intensive industry: construction (red), experiences the most drastic percentage decrease, while
the next highest order (durable goods: red and non durable goods: green) goods have declined at lesser and lesser
rates. The ordered rates of decline coincide with (ABCT)
15




                                                      Works Cited


1
    Mises, Ludwig von. Human Action. 3 ed. San Francisco, CA: Henry Regency Company, 1963. (350)
2
    Rothbard, Murray. America’s Great Depression. 5 ed. Auburn, AL: Ludwig Von Mises Institute, 2000. (3)
3
    Mises, Ludwig von. Human Action. 3 ed. San Francisco, CA: Henry Regency Company, 1963. (32)
4
    Keynes, John M. The General Theory of Employment Interest and Money. New York, NY: Harcourt, Brace and
World Inc. , 1936. (18)
5
    Ibid (249-250)
6
    Ibid (161)
7
    Hazlitt, Henry. The Failure of the New Economics: An Analysis of the Keynesian Fallacies. The Foundation for
Economic Education. Princeton, NJ: D. Van Nostrand Company, 1959. (34-36)
8
    Ibid
9
    Ibid (228-229)
10
     Kirzner, Israel M. "Equilibrium versus the Market Process” Library of Economics and Liberty. (1976),
http://www.econlib.org/library/NPDBooks/Dolan/dlnFMA7.html. (accessed December 3, 2010).
11
     Garrison, Roger. "Austrian Capital Theory and the Future of Macroeconomics Austrian Economics: Perspectives
on the past and Prospects for the Future". (1991), 303-324, http://www.auburn.edu/~garriro/b4mismac.htm.
(accessed December 8, 2010).
12
     Mises, Ludwig von. Human Action. 3 ed. San Francisco, CA: Henry Regency Company, 1963. (Ch18)
13
     Keynes, John M. A Tract on Monetary Reform. 1923.
14
     Rothbard, Murray. America’s Great Depression. 5 ed. Auburn, AL: Ludwig Von Mises Institute, 2000. (8)
15
     Ibid (9)
16
     Ibid (9)
i
    All of Rothbard’s terms and definitions in this section are taken from Mises’ formulation of the “pure time
preference theory” as it is found in his treatise, Human Action.
17
     Rothbard, Murray. America’s Great Depression. 5 ed. Auburn, AL: Ludwig Von Mises Institute, 2000. (11)
18
  Ibid (13)
19
  French, Doug. "Is Housing a Higher Order Good?." November 30, 2009.http://mises.org/daily/3894 (accessed
December 8, 2010).

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Austrian economics

  • 1. Econ 4730 Dr. Quinn Capital Structure and the Animal Spirits Austrian versus Keynesian Business Cycle Theory Alex Benson 12/8/10
  • 2. 1 Introduction Following the stock market crash in October of 1929, the United States was thrown into an economic Depression. The longevity and severity of which was unparalleled in modern capitalist society. This “Great Depression” as it was called seemed to obliterate the conventional (Classical) economic wisdom of the time; and out of this theoretical wreckage two economic schools of thought rose to prominence: Austrian and Keynesian. The Austrians had existed as a heterodox school since the late 19th century, but the Keynesians came in to being as a school of economic thought in response to the Great Depression. While the two schools offered compelling explanations for the catalyst of the recent crash, the explanations themselves could not have been more different. The Austrians School argued that the Depression had been caused by artificially low interest rates set by the central bank, which led to excessive credit creation and mal investment. They believed that when the central bank held interest rates too low for too long, massive inflationary bubbles in investment due to credit creation coincided with artificially low saving; thus a speculative bubble which must inevitably collapse was created. Contrarily, Keynes argued that the Depression was the result of an unemployment equilibrium created by insufficient aggregate demand for goods and services. Keynes argued that such a general glut was possible and therefore rejected the Classical belief in Say’s Law. The following paper will examine the Austrian theory of the Business Cycle as well as the methodology upon which its theory is founded. Interwoven in the following analysis and contrasting the Austrian approach will be examinations of the Austrians chief rival: the Keynesian School. Each school’s arguments will be presented, along with the other’s critiques. However, before an in depth discussion of each school’s competing business cycle theories can be presented, an analysis of their foundations and applicable methodology is required. Methodology Austrian Economics retains the deductive, logical method of its founder, Karl Menger. Whereas the Neoclassical, Keynesian, and other more mainstream schools have adopted intensely mathematical techniques for working through highly aggregated models, the Austrians prefer to view economics as an a priori science. As an a priori science, economics and its
  • 3. 2 propositions are to be justified through rigorous, logical deduction. Mathematics is carried out using various statistics and combining them in different ways so as to produce a product, quotient, sum, difference etc. According to the Austrians it is this quasi definition of mathematics that makes its use so objectionable for use in pure economic study. Economic statistics are by definition products of past economic history. Therefore relying on mathematical manipulations of these statistics is synonymous with a reliance on economic history and experience as a means of study of catallactics. Austrians argue that this usage of mathematics as a means of studying economics transforms the science from a qualitative one into a quantitative one; A quantitative science where econometric models and aggregated variables are seen as superior to a priori deduction1. Murray Rothbard, a giant in the post-Mises Austrian tradition put it best: “Gazing at sheaves of statistics without prejudgment is futile”2. To the Austrians, the highly aggregated and mathematical models of the more mainstream schools oversimplify the complex decisions made in the interplay between consumers and producers. This process of merging all economic decision making into one equation or graphical display is, according to the Austrians, implicitly fallacious because it ignores the heterogeneity of the individual actors in the economy. The Austrians believe that such absolute aggregation ignores the dynamism and ability to quickly restructure markets retained by most important player in any economy: the entrepreneur. Austrians include the science of economics—as most other schools do in one fashion or another—in a broader and more general science of human choice; a science which is exemplified by this deductive process; and a science which Ludwig von Mises called “Praxeology”. Mises explained Praxeology in this way: Its statements and propositions are not derived from experience. They are, like those of logic and mathematics, a priori. They are not subject to verification and falsification on the ground of experience and facts. They are both logically and temporally antecedent to any comprehension of historical facts. They are a necessary requirement of any intellectual grasp of historical events3. As evidenced, Austrians argue against reliance on observed empirical relationships or evidentiary fact as a means of developing economic theory; at least as the primary means of doing so. Evidence to the Austrians can be misleading.
  • 4. 3 In addition to preserving the less formalized and more deductive methodology of earlier generations of economists, the Austrians maintain the Classical adherence to Say’s Law. Put simply, Say’s Law provides that supply creates its own demand. Therefore, there can never be a general glut in demand for goods and services. Obviously, a critique of this declaration would include the assertion that the very presence of an economic recession disproves Say’s law. Since recessions are famous for their ubiquity, it should follow that Say’s law is nothing more than another fallacy of a Classical Economics which excessively concerned itself with growth theory and insufficiently with the trade cycle. Indeed it was Keynes himself, the theoretical converse of the Austrian School, who famously claimed to have disproved Say’s Law in His General Theory. There, Keynes quotes the beginning of a passage on Say’s Law written by John Stuart Mill, in which Mill writes that “What constitutes the means of payment for commodities is simply commodities” and that “could we suddenly double the productive powers of the country… Everybody would be able to buy twice as much because everyone would have twice as much to offer in exchange”4. It is the above formulation of Say’s Law that Keynes refutes. In so doing, he makes the case for government stimulus, either fiscal or monetary; to correct for the gluts that must result provided that Say was wrong. Keynes argues not only that markets, under a complete laissez-faire environment, trend towards overproduction and recession; he argues that such conditions are the norm and that equilibrium can exist at various different levels below full employment. Keynes postulates that: “…the evidence indicates that full, or even approximately full, employment is of rare and short lived occurrence”5 (something both schools, in a sense, agree on). Keynes offers a more theoretical defense of this hypothesis by qualifying the demand for money as determined by income and the interest rate—something the Classical Quantity Theory of Money leaves out. The real interest rate for Keynes is equal to the nominal rate minus the expected rate of inflation; and if this difference is larger than expected deflation, then excessive saving and a general glut (deflation) result. This result, along with a removed and illogical spontaneous optimism which according to Keynes drives much of our positive activities—what Keynes calls the “animal spirits”— work to get the economy into an unemployment equilibrium from which it cannot escape through traditional market forces. Keynes described the Animal Spirits in this way: Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous
  • 5. 4 urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities6. The Austrians, in contrast, offer a defense of Say’s Law. They would point out that Keynes only quoted a fraction of Mill’s statement regarding Say’s Law. The sentences following Keynes’ quotation offer the conditions by which Say’s Law holds. Mill continues by writing that: If we doubled the productive powers of the country, we should not double the supply of commodities in every market, and if we did we should not clear the markets of the double supply in every market… Although the Community would willingly double its aggregate consumption, it may already have as much as it desires of some commodities, and it may prefer to more than double its consumption of others… If so, the supply will adapt itself accordingly, and the values of things will continue to conform to their cost of production”7 This lengthy and somewhat haphazard quotation of Mill is necessary to adequately emphasize the Austrian against the Keynesian view of Say’s Law. The Austrians do not adhere to any belief that there cannot be a relative glut in the economy, nor that specific industries cannot experience a glut corresponding to overproduction in others. The Austrians merely adhere to a formulation of Say’s Law which provides that there can never be a general overproduction of all goods and services8. In reference to Keynes’ point on interest rate determined excesses of saving or investment, Austrians draw the following conclusions. The Austrians disagree with the causal relationship between inflation/deflation and saving/investment posited by Keynes. To the Austrians, it is because of new money and bank credit being created through low interest rates that investment can exceed savings; thus investment exceeds genuine savings because we are in a period of inflation. In the period of liquidation that follows the inflation, it is because bank loans are being repaid and not renewed and the money supply is shrinking that savings exceeds investment: savings exceeds investment because we are in a deflation. Austrians argue that at any one time there is always equality between savings and investment, but there can be “an inequality between prior saving and subsequent investment”. This inequality between saving and investment is the consequence and not the cause of the inflation/deflation being experienced in an economy9. While the Austrians do adhere to a the aforementioned, specific formulation of Say’s Law, they do not share other Neo-Classical beliefs—perhaps better described as assumptions—such as perfectly competitive markets and market equilibrium. Austrians assert that market equilibrium
  • 6. 5 where supply and demand intersect, at one market clearing price, is a fantasy. They supplant this view with the more precise formulation of a dynamic marketplace characterized and driven by a perpetual search for and employment of information. By definition such a characterization of the marketplace assumes imperfect information: another bulwark of the Austrian methodological construct. An absence of perfect information in any economy leads to widespread market ignorance and thus disequilibrium. It is this disequilibrium that is responsible for profit opportunities. The Entrepreneur exploits these opportunities, and in so doing he converts underutilized resources into a more productive capacity. Thus, to the Austrians, the entrepreneur is the most important participant in any economy and the primary driver of economic growth10. The Austrian School’s conceptualization of the capital stock, and interest rates, are the final methodological constructs which must be examined prior to an assessment of the Austrian Business Cycle Theory proper. The Austrians view capital as heterogeneous; meaning that different capital goods are specific to different stages of production, though some capital goods can be shifted between orders of production; in effect varying “the temporal relationship between labor input and consumable output”11. A varying of the “temporal relationship between labor input and consumable output” refers to the fact that shifts can occur in the capital structure as it expands or contracts depending on the time preferences of those in the economy. If time preferences shift towards saving more in the present to consume more in the future, the structure of production expands temporally and more capital goods versus consumer goods are produced. Capital (higher order) goods take more time in their production. During the expanded time period needed for the production of higher order capital, capital which can be shifted does so. Interest, like all other prices in the Austrian framework, is determined subjectively. Austrians assert that the interest rate is determined by the differing time preferences of borrowers and lenders in the economy: time preferences referring to the preference of a current good over a future good (the discounting of future relative to current consumption)12. The relationship between the interest rate, the capital stock, and the money supply is central to the Austrian Theory of the Business Cycle and will be explained more in depth later. In sum, the Austrian’s propose that while the relevant facts and economic data under scrutiny may relate perfectly with a proposed catallactic theory, the relationship itself may be spurious because of some unknown variable. Since it would be impossible to know the spuriousness
  • 7. 6 of a catallactic relationship, only rigorously logical deduction flowing from a priori truths should be used as a means of economic study. It is the process of logical deduction which should guide an economist’s understanding of empirical evidence and statistics. The Austrians adhere to a specific formulation of Say’s Law which does not rule out slumps entirely, merely a general slump affecting every sector of the economy. Finally, the Austrians argue that due to imperfect information, dynamism and change, not equilibrium, exemplify the market. This method of characterizing the economy forms the basis of the Austrians vehement opposition to government involvement in the market process. Keynesian methodology in numerous ways represents the antithesis of that of the Austrians. Accordingly, a juxtaposition of the two schools methodologies helps to explain why, in many ways, their business cycle theories seem to contradict one another. Now that juxtaposition has been offered, we can delve into that even more controversial and applicable argument dividing the two schools of thought: their competing theories of the business cycle. Business Cycle Theory John Maynard Keynes once famously wrote that “The long run is a misleading guide to current affairs. In the long run we are all dead… Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again”13; Keynes was right. He was right in the sense that economists must integrate their studies of the long and the short run (growth and business cycles) if they are to adequately construct a working theory of general economics. Economists who merely trumpet the belief that eventually markets will clear and the “storm” will pass, without a general theory of why the storm came to be in the first place, are in contempt of economics itself. Catallactics requires such integration if it is to be in any way applicable to the real world. The Austrians and Keynesians briefly agree on this point. However their specific diagnoses of and prescriptions for cycle fluctuations drastically deviate from one another. It is to this competing analysis that we now turn. The Keynesian School’s explanation of the business cycle has become a dominant theory in the economics profession. The concept that recessions are caused by a fall off in aggregate demand, leading to a vicious deflationary cycle, is by far the primary theory taught in the contemporary macroeconomics classroom. Because of his theory’s immense popularity, Keynes’ theory of the
  • 8. 7 business cycle will not be outlined in detail. Instead, Keynes’ theories will be mentioned to the extent that they counter the proposals of the Austrian School. Austrian Business Cycle Theory focuses on the role of money and entrepreneurs in the economy. The Austrians seek to explain why, after prolonged periods of astute investment and forecasting decisions, the economy’s entrepreneurs suddenly suffer losses. Put differently: “why is there a sudden general cluster of business errors?”14 The Austrians adhere to the following, admittedly self-evident, formulation of entrepreneurs’ activities: better entrepreneurs, who more successfully forecast investor and consumer demand, make profits; while unsuccessful entrepreneurs suffer losses. In this fashion the market weeds out the less successful entrepreneurs. The Austrians then, through their business cycle theory, are attempting to explain why, if the process occurs as described, large numbers of tested and efficient entrepreneurs suddenly make bad investments and suffer general losses. The Austrians explanation of this cluster of errors, commonly referred to as the business cycle or the “Boom and Bust”, focuses on the role of money in an economy and its ability to distort time preferences and the capital structure. The Austrians argue that in a free market, there can never be a cluster of errors, because all entrepreneurs will not be making mistakes at the same time. To the Austrians, artificial credit expansion to businesses, carried out by banks but always enabled by a central bank and implicit moral hazard, causes such a cluster of errors by facilitating bad investments. These bad investments propagate alongside the artificial credit expansion until the inevitable contraction of the “loose money” strategy; which leads to an eventual bust. In his book America’s Great Depression, Austrian economist Murray Rothbard makes the argument for Austrian Business Cycle Theory (ABCT) by first asking the reader to consider the mechanics of an economy with a fixed money supply. In such an economy, some money is spent on consumption while the rest is saved and then invested into a structure of capital with various orders of production. The determining factor of the proportion of consumption to saving is people’s time preferences, or, “the degree to which they prefer present to future satisfactions”15. The less that is preferred in the present, the lower the time preferences will be, and thus the lower the pure interest rate will be (as it is determined by people’s time preferences). Therefore consumption is foregone in the present in order to pursue more goods in the future. The greater the gap between preferred investment and current consumption, the longer the structure of production: the building
  • 9. 8 up of capital; will be. To the Austrians, the final market interest rate is equal to the pure interest rate plus or minus two components: entrepreneurial risk and purchasing power of the economy’s money. This leads to a dynamic structure of interest rates rather than one uniform rate. The structure of interest rates is majorly determined by the pure interest rate; which in turn is first made manifest in what Rothbard calls the natural interest rate: the going rate of profit reflected in the interest rate in the loan market16. Now that we have established the workings of an economy with a fixed money supply, we can explore what happens when new money is injected into the economy. i When the central bank increases the amount of the money stock—whether in the form of currency or deposits—the interest rate decreases as it appears that vast amounts of new savings are available as funds for investment. Businesses are tricked by the inflation into thinking that saving (as determined by time preferences) has increased, and invest in longer processes of production. Investing in longer processes of production is synonymous with lengthening the capital structure: i.e. higher order or, capital, goods are produced instead of lower order consumption goods more associated with consumers17. None of these effects would necessarily be detrimental to the economy so long as real time preferences expanded alongside the increase in “saving”. However this is not the case as the increase in “saving” was merely an illusion created by the increase in the money supply by the central bank. The new credit eventually finds its way down to the factors of production: mainly and for the sake of this argument, in the form of wages to workers. The workers will of course look for places to spend their new incomes; as the original preferences for saving and consumption have not changed. Workers do not in general purchase higher order (capital) goods, and since time preferences have not changed, they will look to spend their incomes in the same proportions as before. In this scenario, a general oversupply of capital goods exists and businesses will begin to shift their structure of production back towards the old proportions (assuming no government interference). A common argument of the Keynesian School is that recessions are brought on by underconsumption: i.e. overproduction. The Austrians, in one of the great ironies of economics, agree; at least somewhat. To the Austrians, overproduction occurs in the capital goods industries where entrepreneurial demand for higher order goods does not keep pace with excess supply driven by credit expansion. Real demand for higher ordered goods does not increase at all in fact
  • 10. 9 because real time preferences have not changed. In order to move towards profits once again, businesses shift their production back towards lower order goods and away from the higher order goods industries that have been booming. At this point we observe a bust in the previously hyper- expanding higher order industries leading to mass unemployment in those particular sectors. The proper economic policy prescription to deal with general business cycles brought on in this way is to allow for liquidation. Allowing bad investments to fail will eventually bring the interest rate and thus the structure of production back into coordination with consumers’ time preferences. Liquidation does not occur, the Austrians argue, because central banks do not immediately cease their expansion of the money supply. Perpetuation of a loose money policy can “keep the borrowers one step ahead of consumer retribution”18. Additionally, fiscal policy, while not creating the original misallocation of resources, can pervert and slow the market’s recovery by preventing liquidation of the debt and mal-investment catalyzed by this misallocation. If banks and other businesses are considered too big to fail and are saved from bankruptcy, then no progress has been made. Instead, these companies are free to pursue the same mistaken policies as before and investment in the economy is not reallocated to conform to consumers’ real time preferences. If liquidation is prevented, then the boom and bust cycle is perpetuated. Thus we have a complete theory of the business cycle. The central bank expands credit which banks then lend to borrowers as if backed by real saving, though consumers’ time preferences have not changed. This leads to malinvestment in higher order goods which are not demanded by consumers. When malinvestment becomes evident, the inflationary boom ceases and liquidation is necessary to bring consumers’ time preferences and the capital structure of production back into coordination. This liquidation is the depression stage of the business cycle, as liquidation and realignment of investments necessarily will lead to unemployment. Once old investments have been eliminated, the jobs lost can begin to come back as employment opportunities reemerge in free market determined investment. Therefore the Austrians believe that the boom is the period to be leery of. For it is during the boom that cheap credit perverts investment towards higher order goods in a cycle only halted by monetary restraint and liquidation. Obviously many of the tenants of (ABCT) contradict those of its Keynesian rival. While the Austrians assert that credit creation by the central bank creates the boom and bust cycle, the Keynesians would argue that expansionary monetary policy is a necessary and primary means of
  • 11. 10 escaping from unemployment equilibrium (recession) brought on by an imperfect market mechanism. The differing views of the two schools can be attributed mainly to their differing methodology, as described previously. Whereas the Keynesians would view the economy as tending toward unemployment equilibrium due to irrational speculation and the animal spirits, the Austrians would assert that dynamic entrepreneurial profit seeking will keep the economy growing and trending towards full employment (though full employment equilibrium is never achieved in the Austrian Model). Both schools’ theories contain their respective merits, and the two theories represent the two most intellectually rigorous and historically pragmatic visions of the business cycle. In order to better understand the intricacies of (ABCT) against Keynesian theory, it is helpful to study empirical evidence of historical recessions, and correlate evidence with theory. Analysis and Implications Any economic theory which purports to explain the business cycle must conform to some amount of empirical evidence. Even the Austrians agree on this point. The Austrians agree that empirics can help to validate an economic theory; they merely argue that empirics should not be used as inputs in the formation of the theory itself. In that case, it is proper that the historical record pertaining to the most recent “great recession” be examined to find evidence for the validity of (ABCT). If we follow the logic of the business cycle laid out by the Austrian School, then we should observe three primary events preceding the crash in December of 2007. First, we should observe a significant increase in the money supply by the central bank (Federal Reserve). Second, and following from this monetary increase, we should observe substantial booms in investment in higher order, capital intensive industries such as construction. Third, we should observe a leveling out or disinflation of the money supply immediately preceding the bust of the speculative bubble propagated by the boom. Following the recession of 2001, and partly as a panicked reaction to the events of 9/11, the Federal Reserve lowered its federal funds rate from 6.5% (May 2000) to 1% (2003)19. This precipitated a drastic increase in the money supply following 2001—as shown in Table 1; allowing for a drastic reduction in the cost of taking out loans and an expansion of the structure of production, leading to increased longer term (higher order) investment. The most capital intensive
  • 12. 11 and therefore highest order industry, to the Austrians, is construction. It has been made apparent by almost all schools of economics that the housing boom and bust contributed to or was a consequence of the current recession: housing construction, as evidenced, is by definition a higher order industry. The construction industry boomed following the 2001 recession only to be the hardest hit industry after the recession in late 2007. Austrians formulate that the housing boom was a product of the slashing of the federal funds rate and the increase in the money stock following the 2001 recession. As the structure of production expanded due to increased credit availability, higher order goods boomed. However real savings had not increased and therefore real preferences for higher goods among consumers had not increased (Table 4). Therefore, the inevitable bursting of the artificial bubble in construction occurred when the money supply leveled out around 2007 (see Table 1): artificial credit creation no longer existed to the extent that it could perpetuate such malinvestment. Also, the construction industry—an industry of the highest order—experienced the greatest percentage decrease in employment of all capital intensive sectors (Table 5). The Austrians response to such a crisis as we are in now is to allow markets to liquidate bad investment and reallocate the structure of production so as to conform to real savings. As for reform, the Austrians would advocate for the institution of a strict gold standard as a metric for the money supply; and therefore an abolition of the Federal Reserve. The Austrians argue that a strict gold standard would not only make monetary expansion by the Federal Government nearly impossible, it would also help to curtail bank money creation through the fractional reserve system. These views obviously run counter to the Keynesian prescription of allowing for countercyclical monetary and if necessary, fiscal policy as a means of combating recession. To Austrians, this disagreement with Keynes is equivalent to a stamp of legitimacy. The Austrians view Keynesian policy as perpetuating many past crises as well as the current one and therefore, Austrians would argue; it is time for a change.
  • 13. 12 Table 1: Austrian Accepted Measures of the Money Supply TMS is a formulation of the Money Supply created by Murray Rothbard; representing the amount of money in the economy available for immediate use in exchange. TMS consists of the following: Currency Component of M1, Total Checkable Deposits, Savings Deposits, U.S. Government Demand Deposits and Note Balances, Demand Deposits Due to Foreign Commercial Banks, and Demand Deposits Due to Foreign Official Institutions. Source: Ludwig von Mises Institute
  • 14. 13 Table 2: Boom in Construction Employment Source: St. Louis Federal Reserve Table 3: Real Estate Boom
  • 15. 14 Table 4: Personal Savings Depreciation Source: St. Louis Federal Reserve Table 5: Measures of Percentage Decrease in Ordered Industries The most capital intensive industry: construction (red), experiences the most drastic percentage decrease, while the next highest order (durable goods: red and non durable goods: green) goods have declined at lesser and lesser rates. The ordered rates of decline coincide with (ABCT)
  • 16. 15 Works Cited 1 Mises, Ludwig von. Human Action. 3 ed. San Francisco, CA: Henry Regency Company, 1963. (350) 2 Rothbard, Murray. America’s Great Depression. 5 ed. Auburn, AL: Ludwig Von Mises Institute, 2000. (3) 3 Mises, Ludwig von. Human Action. 3 ed. San Francisco, CA: Henry Regency Company, 1963. (32) 4 Keynes, John M. The General Theory of Employment Interest and Money. New York, NY: Harcourt, Brace and World Inc. , 1936. (18) 5 Ibid (249-250) 6 Ibid (161) 7 Hazlitt, Henry. The Failure of the New Economics: An Analysis of the Keynesian Fallacies. The Foundation for Economic Education. Princeton, NJ: D. Van Nostrand Company, 1959. (34-36) 8 Ibid 9 Ibid (228-229) 10 Kirzner, Israel M. "Equilibrium versus the Market Process” Library of Economics and Liberty. (1976), http://www.econlib.org/library/NPDBooks/Dolan/dlnFMA7.html. (accessed December 3, 2010). 11 Garrison, Roger. "Austrian Capital Theory and the Future of Macroeconomics Austrian Economics: Perspectives on the past and Prospects for the Future". (1991), 303-324, http://www.auburn.edu/~garriro/b4mismac.htm. (accessed December 8, 2010). 12 Mises, Ludwig von. Human Action. 3 ed. San Francisco, CA: Henry Regency Company, 1963. (Ch18) 13 Keynes, John M. A Tract on Monetary Reform. 1923. 14 Rothbard, Murray. America’s Great Depression. 5 ed. Auburn, AL: Ludwig Von Mises Institute, 2000. (8) 15 Ibid (9) 16 Ibid (9) i All of Rothbard’s terms and definitions in this section are taken from Mises’ formulation of the “pure time preference theory” as it is found in his treatise, Human Action. 17 Rothbard, Murray. America’s Great Depression. 5 ed. Auburn, AL: Ludwig Von Mises Institute, 2000. (11) 18 Ibid (13) 19 French, Doug. "Is Housing a Higher Order Good?." November 30, 2009.http://mises.org/daily/3894 (accessed December 8, 2010).