Econ 4730Dr. QuinnCapital Structure and theAnimal SpiritsAustrian versus Keynesian Business Cycle TheoryAlex Benson 12/8/10
1 Introduction Following the stock market crash in October of 1929, the United States was thrown into aneconomic Depression. The longevity and severity of which was unparalleled in modern capitalistsociety. 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 ofthought rose to prominence: Austrian and Keynesian. The Austrians had existed as a heterodoxschool since the late 19th century, but the Keynesians came in to being as a school of economicthought in response to the Great Depression. While the two schools offered compellingexplanations for the catalyst of the recent crash, the explanations themselves could not have beenmore different. The Austrians School argued that the Depression had been caused by artificially low interestrates set by the central bank, which led to excessive credit creation and mal investment. Theybelieved that when the central bank held interest rates too low for too long, massive inflationarybubbles in investment due to credit creation coincided with artificially low saving; thus a speculativebubble which must inevitably collapse was created. Contrarily, Keynes argued that the Depressionwas the result of an unemployment equilibrium created by insufficient aggregate demand for goodsand services. Keynes argued that such a general glut was possible and therefore rejected theClassical belief in Say’s Law. The following paper will examine the Austrian theory of the Business Cycle as well as themethodology upon which its theory is founded. Interwoven in the following analysis and contrastingthe Austrian approach will be examinations of the Austrians chief rival: the Keynesian School. Eachschool’s arguments will be presented, along with the other’s critiques. However, before an in depthdiscussion of each school’s competing business cycle theories can be presented, an analysis of theirfoundations and applicable methodology is required. Methodology Austrian Economics retains the deductive, logical method of its founder, KarlMenger. Whereas the Neoclassical, Keynesian, and other more mainstream schools have adoptedintensely mathematical techniques for working through highly aggregated models, the Austriansprefer to view economics as an a priori science. As an a priori science, economics and its
2propositions are to be justified through rigorous, logical deduction. Mathematics is carried out usingvarious 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 itsuse so objectionable for use in pure economic study. Economic statistics are by definition productsof past economic history. Therefore relying on mathematical manipulations of these statistics issynonymous 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 thescience from a qualitative one into a quantitative one; A quantitative science where econometricmodels and aggregated variables are seen as superior to a priori deduction1. Murray Rothbard, agiant in the post-Mises Austrian tradition put it best: “Gazing at sheaves of statistics withoutprejudgment is futile”2. To the Austrians, the highly aggregated and mathematical models of the more mainstreamschools oversimplify the complex decisions made in the interplay between consumers andproducers. This process of merging all economic decision making into one equation or graphicaldisplay is, according to the Austrians, implicitly fallacious because it ignores the heterogeneity ofthe individual actors in the economy. The Austrians believe that such absolute aggregation ignoresthe dynamism and ability to quickly restructure markets retained by most important player in anyeconomy: the entrepreneur. Austrians include the science of economics—as most other schools do in one fashion oranother—in a broader and more general science of human choice; a science which is exemplified bythis deductive process; and a science which Ludwig von Mises called “Praxeology”. Mises explainedPraxeology 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 evidentiaryfact as a means of developing economic theory; at least as the primary means of doing so. Evidenceto the Austrians can be misleading.
3 In addition to preserving the less formalized and more deductive methodology of earliergenerations 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 generalglut in demand for goods and services. Obviously, a critique of this declaration would include theassertion that the very presence of an economic recession disproves Say’s law. Since recessions arefamous for their ubiquity, it should follow that Say’s law is nothing more than another fallacy of aClassical Economics which excessively concerned itself with growth theory and insufficiently withthe trade cycle. Indeed it was Keynes himself, the theoretical converse of the Austrian School, whofamously claimed to have disproved Say’s Law in His General Theory. There, Keynes quotes thebeginning of a passage on Say’s Law written by John Stuart Mill, in which Mill writes that “Whatconstitutes the means of payment for commodities is simply commodities” and that “could wesuddenly double the productive powers of the country… Everybody would be able to buy twice asmuch 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 casefor government stimulus, either fiscal or monetary; to correct for the gluts that must resultprovided that Say was wrong. Keynes argues not only that markets, under a complete laissez-faireenvironment, trend towards overproduction and recession; he argues that such conditions are thenorm and that equilibrium can exist at various different levels below full employment. Keynespostulates that: “…the evidence indicates that full, or even approximately full, employment is ofrare and short lived occurrence”5 (something both schools, in a sense, agree on). Keynes offers amore theoretical defense of this hypothesis by qualifying the demand for money as determined byincome 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 ofinflation; and if this difference is larger than expected deflation, then excessive saving and a generalglut (deflation) result. This result, along with a removed and illogical spontaneous optimism whichaccording 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 throughtraditional 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 Keynesonly 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”7This lengthy and somewhat haphazard quotation of Mill is necessary to adequately emphasize theAustrian against the Keynesian view of Say’s Law. The Austrians do not adhere to any belief thatthere cannot be a relative glut in the economy, nor that specific industries cannot experience a glutcorresponding to overproduction in others. The Austrians merely adhere to a formulation of Say’sLaw 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 relationshipbetween inflation/deflation and saving/investment posited by Keynes. To the Austrians, it isbecause of new money and bank credit being created through low interest rates that investmentcan exceed savings; thus investment exceeds genuine savings because we are in a period ofinflation. In the period of liquidation that follows the inflation, it is because bank loans are beingrepaid and not renewed and the money supply is shrinking that savings exceeds investment: savingsexceeds investment because we are in a deflation. Austrians argue that at any one time there isalways equality between savings and investment, but there can be “an inequality between priorsaving and subsequent investment”. This inequality between saving and investment is theconsequence 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 asperfectly competitive markets and market equilibrium. Austrians assert that market equilibrium
5where supply and demand intersect, at one market clearing price, is a fantasy. They supplant thisview with the more precise formulation of a dynamic marketplace characterized and driven by aperpetual search for and employment of information. By definition such a characterization of themarketplace assumes imperfect information: another bulwark of the Austrian methodologicalconstruct. An absence of perfect information in any economy leads to widespread marketignorance and thus disequilibrium. It is this disequilibrium that is responsible for profitopportunities. The Entrepreneur exploits these opportunities, and in so doing he convertsunderutilized resources into a more productive capacity. Thus, to the Austrians, the entrepreneur isthe 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 finalmethodological constructs which must be examined prior to an assessment of the Austrian BusinessCycle Theory proper. The Austrians view capital as heterogeneous; meaning that different capitalgoods are specific to different stages of production, though some capital goods can be shiftedbetween orders of production; in effect varying “the temporal relationship between labor input andconsumable output”11. A varying of the “temporal relationship between labor input andconsumable output” refers to the fact that shifts can occur in the capital structure as it expands orcontracts depending on the time preferences of those in the economy. If time preferences shifttowards saving more in the present to consume more in the future, the structure of productionexpands temporally and more capital goods versus consumer goods are produced. Capital (higherorder) goods take more time in their production. During the expanded time period needed for theproduction of higher order capital, capital which can be shifted does so. Interest, like all other pricesin the Austrian framework, is determined subjectively. Austrians assert that the interest rate isdetermined by the differing time preferences of borrowers and lenders in the economy: timepreferences referring to the preference of a current good over a future good (the discounting offuture relative to current consumption)12. The relationship between the interest rate, the capitalstock, and the money supply is central to the Austrian Theory of the Business Cycle and will beexplained more in depth later. In sum, the Austrian’s propose that while the relevant facts and economic data underscrutiny may relate perfectly with a proposed catallactic theory, the relationship itself may bespurious because of some unknown variable. Since it would be impossible to know the spuriousness
6of a catallactic relationship, only rigorously logical deduction flowing from a priori truths should beused as a means of economic study. It is the process of logical deduction which should guide aneconomist’s understanding of empirical evidence and statistics. The Austrians adhere to a specificformulation of Say’s Law which does not rule out slumps entirely, merely a general slump affectingevery 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 theeconomy forms the basis of the Austrians vehement opposition to government involvement in themarket process. Keynesian methodology in numerous ways represents the antithesis of that of theAustrians. Accordingly, a juxtaposition of the two schools methodologies helps to explain why, inmany ways, their business cycle theories seem to contradict one another. Now that juxtapositionhas been offered, we can delve into that even more controversial and applicable argument dividingthe 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 tocurrent affairs. In the long run we are all dead… Economists set themselves too easy, too useless atask if in tempestuous seasons they can only tell us that when the storm is past the ocean is flatagain”13; Keynes was right. He was right in the sense that economists must integrate their studies ofthe long and the short run (growth and business cycles) if they are to adequately construct aworking theory of general economics. Economists who merely trumpet the belief that eventuallymarkets will clear and the “storm” will pass, without a general theory of why the storm came to bein the first place, are in contempt of economics itself. Catallactics requires such integration if it is tobe 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 fromone 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 inthe 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 contemporarymacroeconomics classroom. Because of his theory’s immense popularity, Keynes’ theory of the
7business cycle will not be outlined in detail. Instead, Keynes’ theories will be mentioned to theextent that they counter the proposals of the Austrian School. Austrian Business Cycle Theory focuses on the role of money and entrepreneurs in theeconomy. The Austrians seek to explain why, after prolonged periods of astute investment andforecasting decisions, the economy’s entrepreneurs suddenly suffer losses. Put differently: “why isthere a sudden general cluster of business errors?”14 The Austrians adhere to the following,admittedly self-evident, formulation of entrepreneurs’ activities: better entrepreneurs, who moresuccessfully forecast investor and consumer demand, make profits; while unsuccessfulentrepreneurs 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 theprocess occurs as described, large numbers of tested and efficient entrepreneurs suddenly makebad investments and suffer general losses. The Austrians explanation of this cluster of errors, commonly referred to as the businesscycle or the “Boom and Bust”, focuses on the role of money in an economy and its ability to distorttime preferences and the capital structure. The Austrians argue that in a free market, there cannever be a cluster of errors, because all entrepreneurs will not be making mistakes at the sametime. To the Austrians, artificial credit expansion to businesses, carried out by banks but alwaysenabled by a central bank and implicit moral hazard, causes such a cluster of errors by facilitatingbad investments. These bad investments propagate alongside the artificial credit expansion untilthe 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 theargument for Austrian Business Cycle Theory (ABCT) by first asking the reader to consider themechanics of an economy with a fixed money supply. In such an economy, some money is spent onconsumption while the rest is saved and then invested into a structure of capital with various ordersof production. The determining factor of the proportion of consumption to saving is people’s timepreferences, or, “the degree to which they prefer present to future satisfactions”15. The less that ispreferred in the present, the lower the time preferences will be, and thus the lower the pureinterest rate will be (as it is determined by people’s time preferences). Therefore consumption isforegone in the present in order to pursue more goods in the future. The greater the gap betweenpreferred investment and current consumption, the longer the structure of production: the building
8up of capital; will be. To the Austrians, the final market interest rate is equal to the pure interestrate plus or minus two components: entrepreneurial risk and purchasing power of the economy’smoney. This leads to a dynamic structure of interest rates rather than one uniform rate. Thestructure of interest rates is majorly determined by the pure interest rate; which in turn is firstmade manifest in what Rothbard calls the natural interest rate: the going rate of profit reflected inthe interest rate in the loan market16. Now that we have established the workings of an economywith a fixed money supply, we can explore what happens when new money is injected into theeconomy. i When the central bank increases the amount of the money stock—whether in the form ofcurrency or deposits—the interest rate decreases as it appears that vast amounts of new savingsare available as funds for investment. Businesses are tricked by the inflation into thinking thatsaving (as determined by time preferences) has increased, and invest in longer processes ofproduction. Investing in longer processes of production is synonymous with lengthening the capitalstructure: i.e. higher order or, capital, goods are produced instead of lower order consumptiongoods more associated with consumers17. None of these effects would necessarily be detrimental tothe 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 theincrease in the money supply by the central bank. The new credit eventually finds its way down to the factors of production: mainly and forthe sake of this argument, in the form of wages to workers. The workers will of course look forplaces to spend their new incomes; as the original preferences for saving and consumption have notchanged. Workers do not in general purchase higher order (capital) goods, and since timepreferences have not changed, they will look to spend their incomes in the same proportions asbefore. In this scenario, a general oversupply of capital goods exists and businesses will begin toshift their structure of production back towards the old proportions (assuming no governmentinterference). A common argument of the Keynesian School is that recessions are brought on byunderconsumption: 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 industrieswhere entrepreneurial demand for higher order goods does not keep pace with excess supplydriven by credit expansion. Real demand for higher ordered goods does not increase at all in fact
9because 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 ordergoods 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 inthis way is to allow for liquidation. Allowing bad investments to fail will eventually bring the interestrate 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 ceasetheir expansion of the money supply. Perpetuation of a loose money policy can “keep theborrowers one step ahead of consumer retribution”18. Additionally, fiscal policy, while not creatingthe original misallocation of resources, can pervert and slow the market’s recovery by preventingliquidation of the debt and mal-investment catalyzed by this misallocation. If banks and otherbusinesses are considered too big to fail and are saved from bankruptcy, then no progress has beenmade. Instead, these companies are free to pursue the same mistaken policies as before andinvestment in the economy is not reallocated to conform to consumers’ real time preferences. Ifliquidation is prevented, then the boom and bust cycle is perpetuated. Thus we have a complete theory of the business cycle. The central bank expands creditwhich banks then lend to borrowers as if backed by real saving, though consumers’ timepreferences have not changed. This leads to malinvestment in higher order goods which are notdemanded by consumers. When malinvestment becomes evident, the inflationary boom ceases andliquidation is necessary to bring consumers’ time preferences and the capital structure ofproduction back into coordination. This liquidation is the depression stage of the business cycle, asliquidation and realignment of investments necessarily will lead to unemployment. Once oldinvestments have been eliminated, the jobs lost can begin to come back as employmentopportunities reemerge in free market determined investment. Therefore the Austrians believethat the boom is the period to be leery of. For it is during the boom that cheap credit pervertsinvestment 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 theAustrians assert that credit creation by the central bank creates the boom and bust cycle, theKeynesians would argue that expansionary monetary policy is a necessary and primary means of
10escaping from unemployment equilibrium (recession) brought on by an imperfect marketmechanism. The differing views of the two schools can be attributed mainly to their differingmethodology, as described previously. Whereas the Keynesians would view the economy as tendingtoward unemployment equilibrium due to irrational speculation and the animal spirits, theAustrians would assert that dynamic entrepreneurial profit seeking will keep the economy growingand trending towards full employment (though full employment equilibrium is never achieved inthe Austrian Model). Both schools’ theories contain their respective merits, and the two theoriesrepresent the two most intellectually rigorous and historically pragmatic visions of the businesscycle. In order to better understand the intricacies of (ABCT) against Keynesian theory, it is helpfulto 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 someamount of empirical evidence. Even the Austrians agree on this point. The Austrians agree thatempirics can help to validate an economic theory; they merely argue that empirics should not beused as inputs in the formation of the theory itself. In that case, it is proper that the historicalrecord pertaining to the most recent “great recession” be examined to find evidence for the validityof (ABCT). If we follow the logic of the business cycle laid out by the Austrian School, then we shouldobserve three primary events preceding the crash in December of 2007. First, we should observe asignificant increase in the money supply by the central bank (Federal Reserve). Second, andfollowing from this monetary increase, we should observe substantial booms in investment inhigher order, capital intensive industries such as construction. Third, we should observe a levelingout or disinflation of the money supply immediately preceding the bust of the speculative bubblepropagated by the boom. Following the recession of 2001, and partly as a panicked reaction to the events of 9/11, theFederal Reserve lowered its federal funds rate from 6.5% (May 2000) to 1% (2003)19. Thisprecipitated a drastic increase in the money supply following 2001—as shown in Table 1; allowingfor a drastic reduction in the cost of taking out loans and an expansion of the structure ofproduction, leading to increased longer term (higher order) investment. The most capital intensive
11and therefore highest order industry, to the Austrians, is construction. It has been made apparentby almost all schools of economics that the housing boom and bust contributed to or was aconsequence of the current recession: housing construction, as evidenced, is by definition a higherorder industry. The construction industry boomed following the 2001 recession only to be thehardest hit industry after the recession in late 2007. Austrians formulate that the housing boom was a product of the slashing of the federalfunds rate and the increase in the money stock following the 2001 recession. As the structure ofproduction expanded due to increased credit availability, higher order goods boomed. However realsavings had not increased and therefore real preferences for higher goods among consumers hadnot increased (Table 4). Therefore, the inevitable bursting of the artificial bubble in constructionoccurred when the money supply leveled out around 2007 (see Table 1): artificial credit creation nolonger existed to the extent that it could perpetuate such malinvestment. Also, the constructionindustry—an industry of the highest order—experienced the greatest percentage decrease inemployment 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 badinvestment and reallocate the structure of production so as to conform to real savings. As forreform, the Austrians would advocate for the institution of a strict gold standard as a metric for themoney supply; and therefore an abolition of the Federal Reserve. The Austrians argue that a strictgold standard would not only make monetary expansion by the Federal Government nearlyimpossible, 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 countercyclicalmonetary and if necessary, fiscal policy as a means of combating recession. To Austrians, thisdisagreement with Keynes is equivalent to a stamp of legitimacy. The Austrians view Keynesianpolicy as perpetuating many past crises as well as the current one and therefore, Austrians wouldargue; it is time for a change.
12 Table 1: Austrian Accepted Measures of the Money SupplyTMS is a formulation of the Money Supply created by Murray Rothbard; representing the amount ofmoney 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 DemandDeposits and Note Balances, Demand Deposits Due to Foreign Commercial Banks, and Demand DepositsDue to Foreign Official Institutions.Source: Ludwig von Mises Institute
13 Table 2: Boom in Construction EmploymentSource: St. Louis Federal Reserve Table 3: Real Estate Boom
14 Table 4: Personal Savings DepreciationSource: St. Louis Federal Reserve Table 5: Measures of Percentage Decrease in Ordered IndustriesThe most capital intensive industry: construction (red), experiences the most drastic percentage decrease, whilethe next highest order (durable goods: red and non durable goods: green) goods have declined at lesser and lesserrates. The ordered rates of decline coincide with (ABCT)
15 Works Cited1 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 andWorld 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 forEconomic Education. Princeton, NJ: D. Van Nostrand Company, 1959. (34-36)8 Ibid9 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: Perspectiveson 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 timepreference 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 (accessedDecember 8, 2010).