Wednesday, December 8, 2010

Risk and Uncertainty in Post Keynesian Economics

The distinction between risk and uncertainty is fundamental in Post Keynesian economics, as it was in the economic thinking of John Maynard Keynes. While risk can be quantified, uncertainty simply cannot be quantified.

The notion of future uncertainty is partly related to David Hume’s difficult philosophical problem of induction. According to Hume, we have no basis for believing that induction is rational. Human beings use induction out of habit, but there is no rational justification for this belief in induction. Although a full discussion of the problem of induction is not what I want to do here, a few comments can be made.

In brief, induction is the use of a finite number of specific observations to make a general conclusion. The most common form is the use of past observations of events to infer a general conclusion about how nature will behave in the future (e.g., gravity will continue to operate tomorrow or 10 minutes from now). But we can just as easily appeal to observed events in the recent past or present to make a general conclusion about the past (e.g., miracles do not happen in the past). The conclusion of an inductive argument is only probable and never certain.

The trouble is that observation of a finite number of events in the past does not seem to justify the belief that events will continue to happen in this way in the future. One solution to the problem is to assume the uniformity of nature. But even here the assumption that nature is uniform requires an inductive argument, so the reasoning is circular (and note that the radical sense of uncertainty that emerges in the absence of a justification for induction and the uniformity of nature is rather different from Keynesian uncertainty, which relates to future events for which no measurable probability can be given, as we will see below). Various philosophers have tried to solve the problem of induction (Will 1953; Edwards 1965; Strawson 1952; BonJour 1998; Salmon 1974), but many believe there is no satisfactory justification. Hume concluded that we use induction out of habit but with no legitimate basis, and modern evolutionary psychologists might argue that our ability to instinctively reason inductively is an innate property of the brain (like language or moral sentiments), which we have acquired by evolution, even though there is no rational justification for it.

Probably the best solution to the problem of induction (for both the natural and social sciences) is the use of Karl Popper’s critical rationalism (even though Popper’s critical rationalism seems to be widely criticised in modern analytic philosophy [Musgrave 2004: 16–17], and another complaint is that, while many working scientists claim to be Popperians in method, in practice they behave like good Bayesian inductivists [Evans 2007: 33]).

Popper adopts the hypothetico-deductive method, with falsification (not verification) of hypotheses by empirical evidence the key. In hypothetico-deduction, we use the method of forming a hypothesis, deducing predictions or conclusions from it, then empirically testing the predictions or conclusions, and thereby attempting to falsify the hypothesis. Popper comes to an astonishing conclusion:
“I go further than Hume: I hold that inductive procedures simply do not exist (not even low-level ones) and that the story of their existence is a myth” (Popper 1983: 118; see also Musgrave 2004: 18).
Induction is also unnecessary: we simply do not need it. In the natural sciences and other scientific inquiry, what really happens is that we use deduction, especially by means of the modus tollens and the elimination of erroneous hypotheses by empirical evidence, in a process of trial and error (more on this below).

John Maynard Keynes’ Treatise on Probability (1921) was an attempt to answer Hume on the problem of induction. Keynes took the view that induction was justified by a relation of probability which was objective (although later he conceded that probability was not an objective relation). But Keynes also came to argue that there must be a distinction between risk and uncertainty.

Risk is something where a measurable probability can be given to outcomes, e.g., the probability of rolling a 3 when throwing a dice is 1 in 6 (Glickman 2003: 366). In contrast, we face fundamental uncertainty about many other events, and no measurable probabilities can be assigned (e.g., what the interest rate will be in 10 years time). This distinction between risk and uncertainty was also made by Frank Knight.

Keynes’s conception of uncertainty applies to what is technically called a nonergodic stochastic system (Davidson 2002: 187). Our economies are such complex systems, as are many other economic phenomena (e.g., stock markets and financial markets).

We face fundamental ontological or metaphysical uncertainty about many events in the future, a state of affairs which – when applied to economics – can be called “Keynesian uncertainty” (or uncertainty in the sense of Frank Knight, Keynes, George L. S. Shackle and Ludwig Lachmann).

Since there is fundamental uncertainty about many economic variables in the future (particularly in the long-term future), investment decisions cannot be based on a firm calculation of probabilities of future earnings. Since subjective preferences can change in the future, not all investment decisions today will be profitable in the future. The process involved in decision-making about investment and the action of investment itself is not rational calculation.

There is a time difference between production of commodities and the successful sale of those commodities at a profit, and so even the production of commodities has a speculative element, in which decisions to invest in production involve habits of minds, instincts, and conventions.

Thus the investment decisions of a firm are based on expectations of future earnings, which are not necessarily rational at all. When investment decisions are made, they are done under conditions of subjective expectations by business, and the expectations depend on what Keynes called “animal spirits” (for the original concept, see Gerrard 1994). Keynes discussed the factors influencing long-run expectations in Chapter 12 of the General Theory. Because of uncertainty about the future, expectations in investment decisions is not a matter of mathematical calculation. Decisions to invest are taken
“as a result of animal spirits – of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities” (Keynes 2008 [1936]: 144).
The term “animal spirits” was borrowed by Keynes from Descartes (Gerrard 1994: 15), and whether or not modern psychology provides support for Keynes’ idea that we have a “spontaneous urge to action rather than inaction” is really irrelevant. The fundamental point here is that, because of uncertainty about the future and changing subjective preferences of consumers and other exogenous factors driving supply and demand, there can be no genuine rationality in expectations. Expectations are subjective, and the investment decision is essentially non-rational.

There has been a resurgence of interest in subjective expectations since the great recession of 2008/2009, and most notably the New Keynesians George A. Akerlof and Robert J. Shiller have published a book studying this subject (Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, 2009).

Neoclassical economics in its various forms (e.g., general equilibrium analysis, the efficient market hypothesis, and New Classical economics) assumes the ergodic axiom, the belief that the future can be known or events in the future given objective probabilities. But recognition of the ontological uncertainty of events in the future and changing subjective preferences means that events cannot be quantified in terms of probabilities. This destroys the basis of rational expectations and other neoclassical theories.

In the face of the shock of the financial crisis in 2008, the severe global recession in 2008–2009, and debt deflation, business expectations across the world plummeted. The destruction of optimistic expectations is undoubtedly an important factor that will mire many economies around the world in periods of stagnation with low growth and high unemployment in years to come. The Keynesian resurgence and stimulus packages in many countries in 2008–2009 prevented a depression, but much more stimulus is needed in the major economies to restore better growth and to bring unemployment down (there are of course other problems too, such as poorly regulated financial markets and loss of manufacturing in countries like the US that will have to be fixed). Government spending and fiscal stimulus can help to overcome the poor business expectations in many countries.

To return to an earlier point above, how can we justify government intervention in the face of uncertainty? If one accepts that induction can be justified (perhaps along the lines of Will 1953 or Strawson 1952), then obviously one could use an inductive argument for government intervention.

But, if we argue that induction has severe philosophical problems and cannot be justified, how in fact do we justify the hypothesis that government stimulus packages should be used and will work? My answer is that we do not need inductive arguments. We can use Karl Popper’s hypothetico-deductive method to test Keynesian hypotheses about stimulus. Our Keynesian models of stimulus will make predictions about what will happen to an economy, and, if they are not falsified by the empirical evidence, they will have passed the test of falsification, just as they have many times in the past. Popper argued that the hypothetico-deductive method was fundamental to both the natural sciences and social sciences, and he makes a good case for this (Popper 1976: 130–143; Milonakis and Fine 2009: 262–263). In short, induction is unnecessary, and economic methodology can be hypothetico-deductive with falsification of hypotheses by empirical evidence, as M. Blaug (1992) has also argued.

The issue of how Popper’s critical rationalism should be properly applied to economics is not my purpose, and the issue is a difficult one.

Of course, there are numerous economists who do not think that a strict Popperian methodology of economics is workable (Caldwell 1985: 126), and on this subject one can consult as a starting point the critical essays in N. De Marchi (ed.). The Popperian Legacy in Economics: Papers Presented at a Symposium in Amsterdam, December 1985 (Cambridge and New York, 1988), with a response by L. A. Boland (1990–1992).

Lawrence A. Boland contends that economists promoting a Popperian methodology for economics have not fully understood Popper’s critical rationalism, and have been misled by Imre Lakatos’s alleged distortion of Popper’s thought by overemphasizing the role of falsificationism (Boland 2006: 222–223). Boland (2006: 223–224) believes that an Imre Lakatos-inspired and pseudo-Popperian method has been adopted by some proponents of a Popperian methodology for economics.

Although this question requires a post in its own right, there is no doubt that Popper argued for the unity of method and the importance of hypothetico-deduction in the The Poverty of Historicism:
“I … propose a doctrine of the unity of method; that is to say, the view that all theoretical or generalizing sciences make use of the same method, whether they are natural sciences or social sciences …. I do not intend to assert that there are no differences whatever between the methods of the theoretical sciences of nature and of society …. But I agree with Comte and Mill—and with many others, such as C. Menger—that the methods in the two fields are fundamentally the same (though what I understand by them may not be what they had in mind). The methods always amount to deductive causal explanation, prediction, and testing, as sketched in the foregoing section. This has sometimes been called the hypothetico-deductive method, or more often the method of hypothesis, for it does not achieve absolute certainty for any of the scientific statements which it tests; rather, these statements always retain the character of tentative hypotheses, even though their character of tentativeness may cease to be obvious after they have passed a great number of severe tests” (Popper 1976: 130–131).
I will note in conclusion that a Critical Realist methodology is often proposed for Post Keynesianism (King 2002: 197–200; Jespersen 2009), and that this position might be compatible with the core elements of a Popperian methodology too (King 2002: 253–254; Jespersen 2009: 57–62), and that in his later work Popper appears to have moved closer to Critical Realism (Lawson 1999: 8–9).


I noted above that an intuitive ability to reason inductively is probably an innate trait of the human mind, given to us by evolution by natural selection. Animals, for example, appear to use rudimentary induction in probability calculations when they forage for food (Real 1991).

Even though there is no rational justification for it, why then has induction been so successful and obviously selected for as a survival trait? Even if Popper and Hume are right, we are faced with the paradox that we appear use induction very frequently and that it is a successful form of reasoning, by and large (the fact that induction is of limited use in non-ergodic stochastic systems and that we can err in our inductive arguments does not change this fact [for a list of common fallacies in defective inductive reasoning, see Copi and Cohen 2005: 140–145]).

That inductive reasoning has been highly successful and useful in increasing our chances of survival (and was thus selected by evolution) does not necessarily mean that is it rationally justified, of course.

For example, the belief in life after death might very well help some human beings overcome the trauma and stress of losing a loved one or even contemplating their own death (perhaps it might even make them healthier and better able to survive?), but it is still an irrational, unjustified idea.

But the success of induction is presumably explained by the uniformity of nature which has persisted since the first living things with rudimentary inductive reasoning evolved (for example, if the law of gravity had stopped working 1 million years ago, then all land animals would simply have floated off the planet into space and been killed, and there would be no human beings today; the fact that we are here strongly suggests that basic natural laws have remained uniform).

Human beings have also evolved to use induction. I am aware that this is somewhat similar to Willard Van Orman Quine’s (1908–2000) naturalized epistemology and his explanation of why induction is successful. Quine argues that, while Darwinian evolution does not justify induction, it must explain why it is so effective (Derksen 2000: 27–28; Quine 1975; as an aside, Quine also argues that there is no synthetic/analytic distinction. Thus analytic propositions are just firmly-held synthetic propositions, and there are no real a priori propositions. Quine agrees with Popper that the essence of science is the falsificationist hypothetico-deductive method). And, if the uniformity of nature continues to hold in the future, then presumably inductive reasoning will continue to be successful in those areas where it works well.


Akerlof, G. A. and R. J. Shiller, 2009. Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, Princeton University Press, Princeton.

Barkley Rosser, J. 2001. “Uncertainty and Expectations,” in R. P. F. Holt and S. Pressman (eds), 2001. A New Guide to Post Keynesian Economics, Routledge, London and New York. 52–64.

Blaug, M. 1992. The Methodology of Economics, or, How Economists Explain, Cambridge University Press, Cambridge and New York, NY.

Boland, L. A. 2003. “Dealing with Popper in Economic Methodology,” Philosophy of the Social Sciences 33: 477–498.

Boland, L. A. 2006. “Seven Decades of Economic Methodology: A Popperian Perspective,” in I. Jarvie, K. Milford, and D. Miller (eds), 2006. Karl Popper: A Centenary Assessment. Volume III. Science, Ashgate Publishing Ltd., Aldershot, Hants, England. 219–227.

BonJour, L. 1998. In Defense of Pure Reason, Cambridge University Press, Cambridge.

Caldwell, B. J. 1985. Beyond Positivism: Economic Methodology in the Twentieth Century, G. Allen and Unwin, London and Boston.

Copi, I. M. and C. Cohen. 2005. Introduction to Logic (12th edn), Pearson/Prentice Hall, Upper Saddle River, N.J.

Davidson, P. 2002, Financial Markets, Money, and the Real World, Edward Elgar, Cheltenham, UK.

Davidson, P. 2004. “Uncertainty and Monetary Policy,” in P. Mooslechner, H. Schuberth, M. Schürz (eds), Economic Policy under Uncertainty: The Role of Truth and Accountability in Policy Advice, Edward Elgar, Cheltenham, UK and Northampton, MA.

De Marchi, N. (ed.). 1988. The Popperian Legacy in Economics: Papers Presented at a Symposium in Amsterdam, December 1985, Cambridge University Press, Cambridge and New York.

Derksen, T. 2000. “Naturalistic Epistemology, Murder and Suicide? But what about the Promises!,” in L. Decock and L. Horsten (eds), Quine: Naturalized Epistemology Perceptual Knowledge and Ontology, Rodopi, Amsterdam, 2000. 15–34.

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

Edwards, P. 1965. “Bertrand Russell’s Doubts about Induction,” in A. Flew (ed.), Logic and Language, First and Second Series, Doubleday, Garden City, N.Y. 59–85.

Evans, J. St. B. T. 2007. Hypothetical Thinking: Dual Processes in Reasoning and Judgement, Taylor & Francis, Hoboken.

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

Glickman, M. 2003. “Uncertainty,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics, E. Elgar Pub., Cheltenham, UK and Northhampton, MA. 366–370.

Jespersen, J. 2009. Macroeconomic Methodology: A Post-Keynesian Perspective, Edward Elgar Publishing Limited, Cheltenham.

Lawson, T. 1999. “Developments in Economics as Realist Social Theory,” in S. Fleetwood (ed.), Critical Realism in Economics: Development and Debate, Routledge, London and New York. 3–20.

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

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

Milonakis, D. and B. Fine, 2009 From Political Economy to Economics: Method, the Social and the Historical in the Evolution of Economic Theory, Routledge, New York.

Musgrave, A. E. 2004. “How Popper (might have) Solved the Problem of Induction,” in P. Catton and G. Macdonald (eds), Karl Popper: Critical Appraisals, Routledge, Abingdon, Oxon, England. 16–27.

Parsons, S. D. 2003. “Austrian School of Economics,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics, E. Elgar Pub., Cheltenham, UK and Northhampton, MA. 5–10.

Popper, K. 1976. The Poverty of Historicism (1st edn 1957; 2nd corrected edn 1961), Routledge and Kegan Paul, London.

Popper, K. R. 1983. Realism and the Aim of Science, Rowman and Littlefield, Totowa, N.J.

Quine, W. van O. 1975. “The Nature of Natural Knowledge,” in S. Guttenplan (ed.), Mind and Language, Clarendon Press, Oxford. 67–81.

Real, L. A. 1991. “Animal choice behavior and the evolution of cognitive architecture,” Science 253: 980–986.

Runde, J. 1999. “On Popper, Probabilities and Propensities,” in S. Fleetwood (ed.), Critical Realism in Economics: Development and Debate, Routledge, London and New York. 63–82.

Salmon, W. 1974. ‘The Pragmatic Justification of Induction’, in R. Swinburne (ed.), The Justification of Induction, Oxford University Press, Oxford. 85–97.

Skousen, M. 2005. Vienna & Chicago, Friends or Foes?: A Tale of Two Schools of Free-Market Economics, Capital Press/Regnery Pub., Washington, DC.

Strawson, P. F. 1952. Introduction to Logical Theory, Methuen & Co. Ltd, London.

Will, F. L. 1953. “Will the Future Be Like the Past?,” in A. Flew (ed.), Logic and Language: Second Series, Blackwell, Oxford. 32–50.

Sunday, December 5, 2010

The Different Types of Austrian Economics

Although I advocate Post Keynesian economics, I have always been rather intrigued by Austrian economics. In the 1930s, when John Maynard Keynes was establishing the beginnings of the Keynesian revolution, his great intellectual opponent was the Austrian economist Friedrich August von Hayek.

The Austrian school arise in the 1870s as part of the marginalist revolution in economic thought. The founder was Carl Menger, who wrote an influential book called the Principles of Economics in 1871.

In a previous post (see “Friedrich von Wieser and Eugen von Philippovich von Philippsberg: Austrian Economists and Fabian Socialists”), I noted that the early Austrian school was in fact split into two factions: (1) a Classical liberal wing and (2) a wing that was not opposed to government intervention per se, and that even included members sympathetic to Fabian socialism. Hayek explains the history of the Austrian school in this interview:
LEIJONHUFVUD: In economics, let me come back to a question we have touched upon before. In the twenties in Vienna, was there such a thing as an Austrian school in economics? Did you and your contemporaries perceive an identification with a school?

HAYEK: Yes, yes. Although at the same time [we were] very much aware of the division between not only Meyer and Mises but already [Friedrich von] Wieser and Mises. You see, we were very much aware that there were two traditions—the [Eugen von] Böhm-Bawerk tradition and the Wieser tradition—and Mises was representing the Böhm-Bawerk tradition, and Meyer was representing the Wieser tradition.

LEIJONHUFVUD: And where did the line between the two go? Was there a political or politically ideological line involved?

HAYEK: Very little. Böhm-Bawerk had already been an outright liberal, and Mises even more, while Wieser was slightly tainted with Fabian socialist sympathies. In fact, it was his great pride to have given the scientific foundation for progressive taxation. But otherwise there wasn’t really—I mean, Wieser, of course, would have claimed to be liberal, but he was using it much more in a later sense, not a classical liberal (Nobel Prize-Winning Economist: Friedrich A. von Hayek, pp. 49–50).
The split in the Austrian school in the 1920s was between (1) the classical liberal wing of Eugen von Böhm-Bawerk/Mises (which evolved into modern American libertarianism), and (2) the wing of von Wieser, some of whom were leaning towards Fabian socialism.

However, with the migration of Austrian economics to America and the emergence of Mises as a leading figure, the Classical liberal wing won out, and modern Austrian economics developed from the Classical liberal wing under Mises’ influence.

For much of the 1940s, 1950s and 1960s, Mises, Hayek and Rothbard were the major Austrian thinkers. However, there were a number of other less well known third-generation Austrian economists in this era, including Oskar Morgenstern (1902–1976), Gottfried von Haberler (1900–1995), Fritz Machlup (1902–1983), Paul N. Rosenstein-Rodan (1902–1985), and Friedrich A. Lutz (1901–1975). Not all of them were reflexively hostile to government. Paul N. Rosenstein-Rodan, for instance, was famous for his work on how the state can initiate industrialization in poor nations through planned investment (Rosenstein-Rodan 1943).

In the US, the Austrian tradition was strongly influenced by Mises and Rothbard. Then Austrian economics experienced a resurgence in America from the 1970s onwards:
“American Austrianism revolves around an axis that passes through Auburn University, George Mason University, and New York University. It gets its spin from a 1974 conference held at South Royalton, Vermont, a week-long affair that featured lectures by Murray Rothbard, Israel Kirzner, and Ludwig Lachmann” (Garrison 2001: 259).
A proceedings of that conference was later published as The Foundations of Modern Austrian Economics (ed. E. G. Dolan; Mission, Kansas, 1976). For a fascinating discussion of the history of this Austrian resurgence, see Mario Rizzo’s post “What Is Austrian Economics?” (November 23, 2009) at the ThinkMarkets blog and the comments on it.

Modern Austrians come in a number of forms, and there are clear differences between them. In my view, a useful division of modern Austrians would be as follows:
(1) The Anarcho-capitalists
E.g., Murray Rothbard, Hans-Hermann Hoppe and Jörg Guido Hülsmann;

(2) The minimal state/classical liberal Austrians in the tradition of Mises
This variety supports praxeology and utilitarianism;

(3) Hayek’s economics, with a minimal state;

(4) Moderate subjectivist Austrians
E.g., Israel Kirzner and Roger Garrison;

(5) Radical subjectivists like Ludwig M. Lachmann (1906-1990), and Austrians influenced by him.

(see Böhm 1989: 60–61; Hutchison 1994: 222).
One should note that the differences between these types of Austrians are not trivial.

From the 1970s, a new generation of Austrians challenged the older, pure aprioristic methodology of Mises, and advocated a greater role for empirical testing, and Hayek had already moved away from Mises’ methodology with his paper “Economics and Knowledge” (1937).

Personally, I have little time for Austrians of types (1) and (2). The anarcho-capitalists (1) have a radical view that the state must be completely abolished and all of its functions privatized. In the form developed by Rothbard, the case for anarcho-capitalism is based on an untenable and deeply flawed moral argument using natural rights and Aristotelian, neo-Thomist natural law theory (Rothbard 1998). Though my purpose here is not to offer a detailed critique of anarcho-capitalism, one of the most convincing arguments against it is that private protection firms would in fact have an incentive to victimise potential customers to increase market share. Violence of the type that already happens between private mafia groups might occur. A natural monopoly would probably develop as the most powerful firm drove its competitors out of business (or a cartel might become dominant), and one would be left with a de facto state, the very thing anarcho-capitalism sought to abolish! (see Holcombe 2004: 330–331). Moreover, the power relations in an anarcho-capitalist society would appear to be rather like feudalism, with no sense of the common good (Freeman 2001: 147–149). If history is any guide, a movement towards anarcho-capitalism might well result in the kind of incessant violence and warfare between private warlords/protection agencies, as in medieval feudalism. Above all, do we really want to privatise the ownership, use and production of nuclear weapons or biological and chemical weapons? Quite frankly, an anarcho-capitalism system would be one of utter insanity.

The classical liberal Austrians (2) in the tradition of Mises support a minimal state with limited functions, like justice and defence. But Mises’ praxeology is heavily aprioristic, involves an absurd and radical rejection of empirical evidence, and falls apart once one sees the vast number of unsupported subsidiary hypotheses, both present and assumed, that underlie his deductive arguments. Moreover, by admitting the possibility of rational government intervention on utilitarian grounds, Mises’ ideology has a severe logical contradiction (see “Was Mises a Socialist?: Why Mises Refutes Himself on Government Intervention”).

Austrians of type (5) are more interesting. The Austrian radical subjectivists have a “kaleidic” view of economics influenced by the views of the peculiar Austrian–Keynesian hybrid George L. S. Shackle (Lachmann 1976) and stress the subjectivist nature of value, expectations, and knowledge. Lachmann, for example, even denied that free market systems tend to equilibrium or have coordinating processes (Kirzner 2000: 46–47). Lachmann’s radical subjectivism is rejected by Austrians of type (4), who condemned his position as “nihilism” (Kirzner 2000: 47). This rejection is not unreasonable from the perspective of those who support extreme laissez faire economics, because, if there is no neoclassical tendency to full employment equilibrium or Hayek’s plan coordination in a free market system, the alleged economic or moral superiority of such a system collapses. It is thus not surprising that the Lachmann-inspired wing of Austrians aroused some hostility from the moderates who defended the free market as an equilibrating or coordinating mechanism (Dunn 2008: 136).

I am not certain whether Gerald P. O’Driscoll and Mario J. Rizzo are moderate subjectivist Austrians of type (4). Their interesting book The Economics of Time and Ignorance (Oxford, UK, 1985) appears to use Lachmann’s views on the role of time and fundamental uncertainty, but also tries to overcome the charge of “nihilism” by postulating the idea of pattern coordination in place of equilibrium (Gloria-Palermo 1999: 138).

O’Driscoll and Rizzo have made some favourable comments about Post Keynesian economics:
“[i]t is evident that there is much more common ground between post-Keynesian subjectivism and Austrian subjectivism …. the possibilities for mutually advantageous interchange seem significant” (O’Driscoll and Rizzo 1985: 9).
There are indeed some limited similarities in economic analysis between Austrians of type (4) and (5) and the Post Keynesian economists (Böhm 1989: 61).

Paul Davidson, one of leading American Post Keynesians, criticised The Economics of Time and Ignorance in his classic articles “The Economics of Ignorance or Ignorance of Economics?,” Critical Review (1989) 3.3/4: 467–487, and “Austrians and Post Keynesians on Economic Reality: Rejoinder to Critics,” Critical Review 7.2/3 (1993): 423–444. Clearly, there are also very significant differences between Austrians and Post Keynesians.

Austrians of type (4) include Israel Kirzner, who argues that plan/pattern coordination (the Austrian substitute for neoclassical equilibrium) in a free market economy can be achieved by entrepreneurial discovery and creation (Parsons 2003: 7). Type (4) Austrians also include Roger Garrison and others who even engage in “Austrian macroeconomics,” which seems peculiar, given that other Austrians reject the whole concept of macro-theory in economics.

From the perspective of Post Keynesianism, Austrians of type (4) and especially (5) are the most interesting. Ludwig Lachmann, like Keynes, stressed that expectations are subjective, and Lachmann even produced work that has a positive view of aspects of Keynes’ thought. Lachmann’s paper “John Maynard Keynes: A View from an Austrian Window” (South African Journal of Economics 51 (1983): 253–260) argues that
“In the field of methodology Keynes and the Austrians agree that economics is a social science to which methods that have proved successful in the natural sciences should not be applied without careful inspection, …. But Keynes’s mind also moves in another direction. ‘I also want to emphasize strongly the point about economics being a moral science. I mentioned before that it deals with introspection and with values. I might have added that it deals with motives, expectations, psychological uncertainties. One has to be constantly on guard against treating the material as constant and homogeneous. It is as though the fall of the apple to the ground depended on the apple’s motives, on whether it is worthwhile falling to the ground, and whether the ground wanted the apple to fall, and on mistaken calculations on the part of the apple as to how far it was from the centre of the earth’ … Keynes sees in social facts manifestations of the human mind. While to Hayek it is the complexity of these facts, their multitude and diversity, that defies the attribution of numerical values to social concepts, to Keynes it is their mental character … that does so. Rather to the surprise of some of us, Keynes emerges as being more deeply committed to subjectivism than is his Austrian opponent (Lachmann 1983: 256).
These similarities have been noted by other scholars too (Caldwell 1989; Parsons 2003: 6).

Though the practical policy recommendations and political outlook of Post Keynesians and Austrians will remain deeply in conflict, there might be something that Post Keynesians can learn from studying the theories of Austrians of type (4) and (5) above.


In an article published in 1988, Walter Block proposes a useful division of different types of Austrian subjectivism:
1. The nonsubjectivists
2. The moderate subjectivists (i.e., Yeager)
3. The Austrian subjectivists (i.e., Rothbard, Kirzner, Buchanan)
4. The ultra- or extreme subjectivists (i.e., Jack Wiseman, G.L.S. Shackle, Ludwig Lachmann, and “hermeneuticians” associated with the market process group located at George Mason University) (Block 1988: 201).
Categories (2) and (3) here include my category of “Moderate subjectivist Austrians.”


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Block, W. 1988. “On Yeager’s ‘Why subjectivism?,’” Review of Austrian Economics 2: 199–208.

Caldwell, B. J. 1989. “Post-Keynesian Methodology: An Assessment,” Review of Political Economy 1465-3982, Volume 1, Issue 1, 1989, Pages 43 – 64

Dolan, E. G. (ed.). 1976. The Foundations of Modern Austrian Economics, Sheed & Ward, Mission, Kansas.

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Freeman, S. R. 2001. “Illiberal Libertarians: Why Libertarianism Is Not a Liberal View,” Philosophy & Public Affairs 30.2: 105–151.

Garrison, R. W. 2001. Review of Subjectivism in Economic Analysis: Essays in Memory of Ludwig M. Lachmann (Routledge, London, 1998), Review of Political Economy 13.2: 258–262.

Gloria-Palermo, S. 1999. The Evolution of Austrian Economics: From Menger to Lachmann, Routledge, London and New York.

Holcombe, R. G. 2004. “Government: Unnecessary but Inevitable,” Independent Review 8.3: 325–342.

Honderich, T., 2005. Conservatism: Burke, Nozick, Bush, Blair? (rev. edn), Pluto, London.

Hutchison, T. W. 1994. The Uses and Abuses of Economics: Contentious Essays on History and Method, Routledge, London.

Kirzner, I. M. 2000 The Driving Force of the Market: Essays in Austrian Economics, Routledge, New York.

Lachmann, L. M. 1976. “From Mises to Shackle: An Essay on Austrian Economics and the Kaleidic Society,” Journal of Economic Literature 14.1: 54-62.

Parsons, S. D. 2003. “Austrian School of Economics,” in J. E. King (ed.), The Elgar Companion to post Keynesian Economics, E. Elgar Pub., Cheltenham, UK and Northhampton, MA. 5–10.

Rosenstein-Rodan, P. N. 1943. “Problems of Industrialization of Eastern and South-Eastern Europe,” Economic Journal 53.210/211: 202–211.

Rothbard, M. N. 1998. The Ethics of Liberty, New York University Press, New York and London.

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

Yeager, L. B. 1987. “Why Subjectivism?,” Review of Austrian Economics 1: 5–31.

Wednesday, October 27, 2010

Mises on Fascism in 1927: An Embarrassment

Ludwig von Mises was a lifelong advocate of Classical liberalism, and he opposed socialism, Marxism and other totalitarian systems. It is perfectly clear that Mises was a strong opponent of authoritarian regimes, and never directly supported such systems. It is necessary to stress this fact.

But in 1927 Mises published a book in German called Liberalismus (Gustav Fischer Verlag, Jena). I quote from the 1978 edition called Liberalism: A Socio-Economic Exposition (Mission, Kansas, 1978). In this book, Mises gives a negative and critical summary of the characteristics of 1920s European fascism (and, to be fair, this was before the horrors of 1930s Nazism). Mises principally has in mind the Italian fascism of Benito Mussolini, who had become Prime Minister of Italy in 1922.

Mises notes the violent and murderous nature of revolutionary socialism in the Third International (pp. 47–49), and contends that fascism arose as a response to these tactics. Yet for Mises, “the great danger threatening domestic policy from the side of fascism lies in its complete faith in the decisive power of violence” (p. 50). Mises even notes that ideas are more important weapons than violence, and that classical liberalism is the “only one idea that can be effectively opposed to socialism” (pp. 50–51).

How surprising it is, then, to read this conclusion to Mises’ section on fascism (I include the original German):
“Soviel über die innerpolitische Stellung des Faszismus. Daß er außenpolitisch durch das Bekenntnis zum Gewaltprinzip im Verhältnis von Volk zu Volk eine endlose Reihe von Kriegen hervorrufen muß, die die ganze moderne Gesittung vernichten müssen, bedarf keiner weiteren Ausführung. Der Fortbestand und die Fortentwicklung der wirtschaftlichen Kultur der Gegenwart verlangen Sicherung des Friedens zwischen den Völkern. Die Völker aber können sich nicht vertragen, wenn sie von einer Ideologie beherrscht werden, die glaubt, durch Gewalt allein die Stellung des eigenen Volkes im Kreise der Völker sichern zu können.

Es kann nicht geleugnet werden, daß der Faszismus und alle ähnlichen Diktaturbestrebungen voll von den besten Absichten sind und daß ihr Eingreifen für den Augenblick die europäische Gesittung gerettet hat. Das Verdienst, das sich der Faszismus damit erworben hat, wird in der Geschichte ewig fortleben. Doch die Politik, die im Augenblick Rettung gebracht hat, ist nicht von der Art, daß das dauernde Festhalten an ihr Erfolg versprechen könnte. Der Faszismus war ein Notbehelf des Augenblicks; ihn als mehr anzusehen, wäre ein verhängnisvoller Irrtum” (Mises 1927: 45).

“So much for the domestic policy of Fascism. That its foreign policy, based as it is on the avowed principle of force in international relations, cannot fail to give rise to an endless series of wars that must destroy all of modern civilization requires no further discussion. To maintain and further raise our present level of economic development, peace among nations must be assured. But they cannot live together in peace if the basic tenet of the ideology by which they are governed is the belief that one's own nation can secure its place in the community of nations by force alone.

It cannot be denied that Fascism and similar movements aiming at the establishment of dictatorships are full of the best intentions and that their intervention has, for the moment, saved European civilization. The merit that Fascism has thereby won for itself will live on eternally in history. But though its policy has brought salvation for the moment, it is not of the kind which could promise continued success. Fascism was an emergency makeshift. To view it as something more would be a fatal error” (Mises 1978: 51).
For all of his denunciation of, and opposition to, Fascism both here and elsewhere, and his correct prediction that fascist aggression would lead to war, Mises still wrote that “fascism and similar movements aiming at the establishment of dictatorships are full of the best intentions and that their intervention has, for the moment, saved European civilization. The merit that Fascism has thereby won for itself will live on eternally in history.

How wrong Mises was. Having correctly noted that fascism’s foreign policy was based on the “avowed principle of force in international relations” and that this would cause disastrous wars, Mises still declares that fascism was “full of the best intentions.” How often have Marxists made this sort of defence of communism despite all the evils of the Soviet Union?

In another passage, Mises contended that the violence and authoritarianism of fascism had been provoked by the equally violent and brutal nature of revolutionary socialism:
“The deeds of the Fascists and of other parties corresponding to them were emotional reflex actions evoked by indignation at the deeds of the Bolsheviks and Communists. As soon as the first flush of anger had passed, their policy took a more moderate course and will probably become even more so with the passage of time” (Mises 1978: 49).
Mises was ridiculously wrong about fascism moderating “with the passage of time.” On the issue of fascism in these passages, he was a hypocrite, and, at best, naïve. At worst, what was he? Well, I will leave that up to readers to decide.

While this certainly does not mean that Mises directly supported fascism and fascist ideology (and please note that I am not saying this), his astonishingly positive remarks about fascism in the 1920s cannot be wished away. Frankly, these comments are an utter embarrassment and disgrace to Mises.

Now does all this prove that Mises’s extreme free market economics are wrong, merely on the basis of his contemptibly stupid views on fascism? Of course not. To argue so would be an unsound ad hominem argument, as invalid as the lazy Austrian ad hominem attacks on Keynes (Rothbard’s “Keynes the Man” stands out as a particularly egregious example). But it certainly does not reflect well on Mises’s personal opinions and the morality and consistency of his political views.


An interesting addendum to the post above is Mises’ attitude to the fascist regime that took over Austria in 1933.

Engelbert Dollfuss had been a member of the Austrian Christian Social Party, and became Chancellor of Austrian in 1932. In March 1933, Dollfuss took advantage of the political turmoil in the Austrian parliament, effectively abolished democracy, and established an authoritarian regime. While Dollfuss was an opponent of the Austrian branch of the Nazi party (the Austrian National Socialists or DNSAP), he banned other political parties and established his own peculiar fascist political alliance called the “Patriotic Front” (Vaterländische Front), which included the Christian Social Party and other nationalists and conservatives. Dollfuss was assassinated in July 25, 1934 by Austrian Nazis, but was succeeded by Kurt Schuschnigg, who was Chancellor from July 1934 to the Anschluss in March 1938.

Around March 1934, Mises moved to Geneva, Switzerland, where he taught at the Graduate Institute of International Studies. However, he continued to visit Austria in subsequent years, and still worked part time for the Vienna Chamber of Commerce (Hülsmann 2007: 684). It is claimed that before 1934 Mises had become an adviser to Dollfuss (see Hans-Hermann Hoppe, “The Meaning of the Mises Papers,”, April 1997). Even as late as autumn 1937 Mises considered returning to Austria to work for the Austrian Chamber of Commerce full time (Hülsmann 2007: 723), and only finally fled Austria permanently on one of his regular visits in March 1938 before the Nazi takeover. I quote from J. G. Hülsmann’s biography of Mises:
“Mises later said that it was the growing power of the Nazi party in Austria that prompted him to leave the country. With this remark, he did not refer to the government of Engelbert Dollfuss, which had reintroduced authoritarian corporatism into Austrian politics to resist the socialism of both the Marxist and the Nazi variety. Mises meant the Austrian branch of the National Socialist German Workers Party, which enjoyed strong backing from Berlin and fought a daily battle to conquer the streets of Vienna. Dollfuss’s authoritarian policies were in his view only a quick fix to safeguard Austria’s independence—unsuitable in the long run, especially if the general political mentality did not change” (Hülsmann 2007: 683–684).
If correct, then Mises saw Dollfuss’s fascism in much the same way as Mussolini’s fascism: as an “emergency makeshift.”


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

Mises, L. von, 1927. Liberalismus, G. Fischer, Jena.

Mises, L. von, 1978. Liberalism: A Socio-Economic Exposition (2nd edn; trans. R. Raico), Sheed Andrews and McMeel, Mission, Kansas.

Saturday, October 23, 2010

The US Recession of 1920–1921: Some Austrian Myths

The US recession of 1920–1921 is endlessly cited by Austrians as proof that Keynesian economic policies are not needed to stimulate an economy out of recession or depression. Unfortunately, Austrians are deeply ignorant about the recession of 1920–1921. This recession was atypical, occurred shortly after the WWI, and recent research shows that the GDP contraction was not especially severe.

We can list some basic facts about the 1921 recession below and how these facts do not support the Austrian/libertarian myths one endlessly hears on their blogs:
(1) Duration of the Recession
The recession lasted from January 1920 to July 1921 (a period of 18 months). From January 1920 until July 1920 the recession was mild, and only became severe after July 1920 (Vernon 1991: 573), and the downturn persisted until July 1921.

Libertarians claim that the recession of 1920–1921 was short. Of course, what they don’t say is that a recession lasting 18 months is in fact a very long one by the standards of the post-1945 US business cycle. The average duration of US recessions in the post-1945 era of classic Keynesian demand management (1945–1980) and the neoliberal era (1980–2010) has been about 11 months (see Carbaugh 2010: 248 and the data in Knoop 2010: 13; curiously, there has only been one post-1945 US recession that lasted 18 months: the Great Recession of December 2007–June 2009, which was much worse than the 1920–1921 downturn). The average duration of recessions in peacetime from 1854 to 1919 was 22 months (Knoop 2010: 13), and the average duration of recessions from 1919 to 1945 was 18 months (Knoop 2010: 13).

In the post 1945 period this was cut to about 11 months. Thus the average duration of recessions was essentially cut in half after 1945, because of countercyclical fiscal and monetary policy. Even expansions in the post-1945 business cycle became longer: the average duration of post-1945 expansions was 50 months. By contrast, the average duration of expansions from 1854 to 1919 was 27 months, and the average from 1919 to 1945 was 35 months (Knoop 2010: 13). In other words, the average length of post-1945 expansions became 43% higher compared with that of 1919 to 1945, and 85% higher than between 1854 to 1919.

Macroeconomic performance after 1945 has been superior, without any doubt, to that of the previous gold standard eras. The recession of 1920–1921 with a duration of 18 months was in fact of long duration relative to the average of post-1945 recessions. Keynesian and even neoliberal economic management of the business cycle has been superior to the system that existed before 1933.

The empirical data tells us that, if Keynesian stimulus had been applied early in 1920, there are convincing reasons for thinking that the contraction would have been far shorter than 18 months.

(2) Severity of the Recession
Libertarians seem unaware that recent economic research has shown that the downturn of 1920–1921 was not as severe as previously thought. The widely accepted definition of a depression is a fall of 10% in output or GDP. In past estimates of the fall in national output, official Commerce Department data suggested that GNP fell 8% between 1919 and 1920 and 7% percent between 1920 and 1921 (Romer 1988: 108).

But Christina Romer has argued that actual decline in real GNP was only about 1% between 1919 and 1920 and 2% between 1920 and 1921 (Romer 1988: 109; Parker 2002: 2). So in fact real output moved very little, and this was not a depression on the scale of 1929–1933 or previous 19th century depressions. Libertarians cannot claim that 1920–1921 was an example of the free market quickly ending a downturn where output collapsed by 10% or more (a real depression). In reality, GNP contraction was relatively small, and the growth path of output was hardly impeded by the recession (Romer 1988: 108–112; Parker 2002: 2).

(3) Deflation and Positive Supply Shocks
Although deflation was very severe, one significant cause of the deflation was a positive supply shock in commodities due to the resumption of shipping after the war (Romer 1988: 110). After WWI, there was a recovery in agricultural production in Europe, even though American farmers had continued their production at wartime levels. When primary commodity supplies from other countries were resumed after international shipping recovered, there was a great increase in the supply of commodities and their prices plummeted. As Romer argues,
“Tiffs suggests that a flood of primary commodities may have entered the market following the war and thus driven down the price of these goods. That these supply shocks may have been important in stimulating the economy can be seen in the fact that the response of the manufacturing sector to the decline in aggregate demand in 1921 was very uneven …. The industries that were most devastated by the downturn were those in heavy manufacturing …. On the other hand, nearly all industries… that used agricultural goods or imports as raw materials experienced little or no decline in labour input in 1921 .... That industries related to agricultural goods and imports flourished during 1921 suggests that beneficial supply shocks did stimulate production in a substantial sector of the economy” (Romer 1988: 111).
Vernon (1991) comes to the same conclusion as Romer: the deflation in 1920-1921 was caused not just by a decline in aggregate demand but also by a positive aggregate supply shock. Another factor is that deflationary expectations were high after the war, as prices over the 1914–1920 period had increased by 115% (Vernon 1991: 577). This means that business was expecting deflation. We can contrast this with the 1929–1933 period when severe deflation was largely unexpected, and had much more harmful consequences.

(4) No Major Financial Crisis
The recession of 1920–1921 also had no serious financial crisis: although some bank failures occurred, there were no mass bank runs and collapses in 1920–1921 (Brunner 1981: 44). Stock market prices had been high before 1920 and overvalued and hit a peak 2 months before the onset of the recession. But this stock market bubble does not appear to have been caused by excessive private debt and leveraged speculation as in 1929. We can also note that the explosive rise in consumer credit to households and small businesses only occurred in the course of the 1920s (Parker 2002: 2), and thus large levels of private debt were clearly not a significant factor in 1920/1921. Thus debt deflationary effects were not as serious as in other recessions, and certainly not like the downturn of 1929–1933.

(5) The Federal Reserve’s Role
It is perfectly clear that the Federal Reserve had a role both in contributing to the cause of the recession and in ending it. As Vernon (1991: 573) notes,
“Monetary policy began to shift in December 1919, then changed markedly in January 1920. The Federal Reserve Bank of New York’s discount rate, which had been pegged at 4 percent since April 1919, was raised to 4.75 percent in December 1919, to 6 percent in January 1920, and to 7 percent in June 1920. Similar discount rate increases were made at the other Federal Reserve Banks. Friedman and Schwartz argue that these sharp increases came too late to be responsible for the January 1920 turning point but that they produced the severe contraction and deflation which came after mid-year.”
But, by 1921, there was monetary loosening. In April and May 1921, Federal Reserve member banks dropped their rates to 6.5% or 6%. In November 1921, there were further falls in discount rates: rates fell to 4.5% in the Boston, Philadelphia, New York, and to 5% or 5.5% in other reserve banks (D’Arista 1994: 62).

The role of the Federal Reserve underscores how the recession of 1920–1921 was not like US downturns in the 19th century, since the US had no central bank before 1914 (and after 1836 when the charter of the Second Bank of the United States expired). If we admit that Fed policy contributed to the recession, then it is highly probable that Fed easing of interest rates in 1921 also had a role in ending the recession, because the relatively lower interest rates after May 1921 preceded the expansion that ended the recession (which began in July 1921).

The recovery, then, has to be partly related to central bank policy, not to the pure free market eulogised by Austrian economists. (And in fact one of the reasons why there was no sharp recession after WWII was that the Federal Reserve kept interest rates very low after 1945 [Vernon 1991: 580]).
In light of all this, the recession of 1920–1921 was very different from the contraction of 1929–1933 and various other pre-1914 recessions that were preceded by excessive private debt, and caused by bursting asset bubbles, severe financial crises, demand contractions and debt deflation.

An obvious example of such a 19th century depression was that of 1893-1895. This was set off by a financial crisis in 1893 and caused the US to suffer high involuntary unemployment throughout the 1890s, even after a technical recovery had begun in 1895 (on this depression, see Steeples and Whitten 1998; Akerlof and Shiller 2009: 59-64; Romer 1986: 31).

The belief that the recovery in 1921 proves that a laissez faire or “do nothing” policy will work in other cases of serious recession or depression is utter nonsense. Above all, the empirical data show that modern macroeconomic policies have reduced the durations of recessions after 1945. There is no reason why in principle the 1920–1921 recession could have been alleviated and brought to an end sooner if countercyclical fiscal policy had been used.

I have recently seen an article by Daniel Kuehn called “A critique of Powell, Woods, and Murphy on the 1920–1921 depression.”
This also presents a critique of the Austrian view of the 1920-21 recession:

Kuehn also draws attention to the role of the Federal Reserve, and argues that its high discount rate (the primary policy tool in those days) in 1920 to combat inflation was a major factor in inducing the recession.

UPDATE 2, 18 January, 2011
I have just seen this page on the Mises forum where someone has copied my post above:

A commentator there has in fact unintentionally provided an important counterargument against the Austrians.

If Austrians think that the 1890s recession and high unemployment in that decade do not provide evidence against their theories (since the US had a national banking system and fractional reserve banking in the 1890s, instead of the pure laissez faire they advocate), then why on earth do they endlessly invoke 1920–1921 as if it proves the Austrian position?

If they really believe that 1890s America (where there was no central bank) cannot be invoked as a criticism of Austrian theory, then it is absurd in the extreme for Austrians to invoke 1920–1921 as vindication of their theories, when, in that period, America had a central bank! By your own definition, it was even less of a laissez faire system than 1890s America.

And, of course, given there was no period in recent history when the fantasy Austrian world of no fractional reserve banking, no fiduciary media, no regulation, and no government has ever even existed, there is no empirical evidence whatsoever that such a system would work or be stable.

All one can do is look to real world capitalism in the 19th century: given there was no central bank, a gold standard and minimal regulation in 1890s America, this must give at least an approximation of what their system would look like.
If Austrians think it is not an approximation, then the 1920–1921 period is utterly invalid too, in any attempt to vindicate their theory.

In short, this is another severe logical contradiction running through Austrian analysis.

All GNP figures are merely estimates, since proper data collection was not done before about 1945. There are four important studies on GNP before 1945:

Balke, N. S., and R. J. Gordon, 1986. “The American Business Cycle: Continuity and Change,” in R. J. Gordon (ed.), The American Business Cycle, University of Chicago Press, Chicago.

Balke, N. S., and R. J. Gordon, 1989. “The Estimation of Prewar Gross National Product: Methodology and New Evidence,” Journal of Political Economy 97.1: 38–92.

Romer, C. 1989. “The Prewar Business Cycle Reconsidered: New Estimates of Gross National Product, 1869-1908,” Journal of Political Economy 97.1: 1–37.

Ritschl, A., Sarferaz, S. and M. Uebele, “The U.S. Business Cycle, 1867–2006: Dynamic Factor Analysis vs. Reconstructed National Accounts,” January, 2010

The various estimates for 1920–1921 GNP:

The U.S. Department of Commerce = 6.9% GNP decline

Balke and Gordon = 3.5% GNP decline

Romer = 2.4% GNP decline

Balke and Gordon’s figures support a much lower decline for GDP.

The estimate of Ritschl, Sarferaz, Uebele (2010) is higher than that of Balke and Gordon and Romer.

For data on the persistence of double digit unemployment in the 1890s, see the revised figures in Romer 1986: 31.

Year Unemployment rate
1892 3.72%
1893 8.09%
1894 12.33%
1895 11.11%
1896 11.965
1897 12.43%
1898 11.62%
1899 8.66%
1900 5.00%

The US economy did not return to full employment for nearly a decade after 1893. Contrary to Austrian economic analysis, there is no evidence that the 1890s slump was rapidly ended by a laissez faire economy. In fact, since the US had no central bank in the 1890s, Austrians and other free market libertarians should be doubly embarrassed by the downturn in the 1890s and the persistence of high unemployment and sub-optimum growth.

The other widely used estimate of unemployment in the 1890s is the work of Stanley Lebergott. His estimates of unemployment are much higher than Romer’s, so, even if his estimates are invoked as more accurate than Romer’s, they would only make matters worse for the libertarian position.

And one might argue that Romer’s estimates are questionable (Lebergott 1992), and at least for the period from 1900-1929 (Weir 1986), as the idea that movements in the labour force were procyclical before 1945 can be challenged: if aggregate participation rates were anticyclical, then Lebergott’s estimates for 1900-1929 may be better (Weir 1986: 364; Weir 1992, however, does agree that Lebergott’s figures for 1890-1899 are too volatile). Here are Lebergott’s estimates of the unemployment rate:

Year Unemployment rate
1890 4.0
1891 5.4
1892 3.0
1893 11.7
1894 18.4
1895 13.7
1896 14.5
1897 14.5
1898 12.4
1899 6.5
1900 5.0

Akerlof, G. A. and R. J. Shiller. 2009. Animal Spirits: How Human Psychology drives the Economy, and Why it Matters for Global Capitalism, Princeton University Press, Princeton.

Brunner, K. 1981. The Great Depression Revisited, Nijhoff, Boston and London.

Carbaugh, R. J. 2010. Contemporary Economics: An Application Approach, M.E. Sharpe, Armonk, New York.

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

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

Lebergott, S. 1964. Manpower in Economic Growth: The American Record since 1800, McGraw-Hill, New York.

Lebergott, S. 1992. “Historical Unemployment Series: A Comment,” Research in Economic History 14: 377–386.

Parker, R. E. 2002. Reflections on the Great Depression, Edward Elgar, Cheltenham, Northampton, MA.

Romer, C. 1986. “Spurious Volatility in Historical Unemployment Data,” Journal of Political Economy 94.1: 1–37.

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

Romer, C. 1989. “The Prewar Business Cycle Reconsidered: New Estimates of Gross National Product, 1869-1908,” Journal of Political Economy 97.1: 1–37.

Steeples, D. W. and D. O. Whitten, 1998. Democracy in Desperation: The Depression of 1893, Greenwood Press, Westport, Conn.

Vernon, J. R. 1991. “The 1920–21 Deflation: The Role of Aggregate Supply,” Economic Inquiry 29: 572–580.

Weir, D. R. 1986. “The Reliability of Historical Macroeconomic Data for Comparing Cyclical Stability,” The Journal of Economic History 46.2: 353–365.

Weir, D. R. 1992. “A Century of U.S. Unemployment, 1890–1990: Revised Estimates and Evidence for Stabilization,” Research in Economic History 14: 301–346.

Thursday, October 21, 2010

Friedrich von Wieser and Eugen von Philippovich von Philippsberg: Austrian Economists and Fabian Socialists

Unlike the title of my earlier post on Mises (see “Was Mises a Socialist?: Why Mises Refutes Himself on Government Intervention”), the title of this post is not in jest.

The Austrian school of economics traces its origins back to the Austrian founder Karl Menger (1840–1921), and the first generation of Austrian economists were Friedrich von Wieser, Eugen von Böhm-Bawerk, and Eugen von Philippovich von Philippsberg (see the “Austrian School,” for a short history). In the 1940s a branch of the Austrian school sprung up in America under the influence of Ludwig von Mises (a second generation Austrian), whose student Murray Rothbard was the developer of anarcho-capitalism. Yet another tradition is derived from the work of Friedrich August von Hayek, a third generation Austrian.

And now for what might be a bombshell for some people. Two of the first generation of Austrian economists were clearly supporters of Fabian socialism. Yes, you heard me right: they were advocates of early 20th century Fabian socialism.

First, let’s start with Eugen von Philippovich von Philippsberg (1858–1917). Eugen von Philippovich studied under Karl Menger, taught at the University of Freiburg im Breisgau, and returned to the University of Vienna in 1893 as a professor of economics (Hülsmann 2007: 83). Philippovich was already in favour of state intervention before he taught at Vienna. On his return as a Professor in 1893,
“he immediately joined the Vienna Fabians. The group organized public conferences and discussions to promote the idea of government intervention in the service of a “social” agenda, which primarily concerned the support of the working-class poor. Philippovich’s personal and intellectual qualities made him the center of the Vienna Fabians and helped spread their influence among academics and businessmen. These activities were so successful that Fabian ideas eventually were incorporated into the programs of all Austrian political parties” (Hülsmann 2007: 83).
Eugen von Philippovich was not alone in such views.

Baron Friedrich von Wieser (1851–1926), another first generation Austrian economist, was sympathetic to Fabian socialism as well and not hostile to government intervention per se.

Friedrich von Wieser was born in 1851, and took a degree from the University of Vienna in 1872. After historical interests, he came to study economics after reading Karl Menger’s Grundsatze (for Wieser’s life, see Schumpeter 1997: 298ff; Schumpeter and Achille Loria 1927). From 1903 he succeeded Menger at the University of Vienna where he taught economics along with his brother-in-law Eugen von Böhm-Bawerk. Friedrich von Wieser was the teacher of Friedrich August von Hayek.

A. O. Ebenstein, in his Friedrich Hayek: A Biography (Chicago, 2003), provides a good summary of von Wieser’s economics:
“Wieser was more corporatist and intervention-minded than Böhm-Bawerk and Menger. Hayek recalled that when he was a student, he was ‘very much aware that there were two traditions’ in the Austrian school — the ‘Böhm-Bawerk tradition and the Wieser tradition. Wieser was slightly tainted with Fabian socialist sympathies. Hayek observed of his later relationship with Mises, who ‘represented the Böhm-Bawerk tradition,’ that ‘I perhaps most profited from his teaching because I came to him as a trained economist, trained in a parallel branch of Austrian economics from which he gradually, but never completely, won me over” (Ebenstein 2003: 26).
Friedrich August von Hayek was a direct student of Friedrich von Wieser. And what’s more Hayek in his youth shared von Wieser’s Fabian socialist leanings: A. O. Ebenstein notes that Hayek had a“mild, Fabian socialist phase … from about the ages of seventeen to twenty-five” (that is, from about 1916 to 1924), though Hayek never accepted Marxist socialism (Ebenstein 2003: 23).

Why did Hayek become a student of von Wieser? We can go straight to the horse’s mouth. Hayek himself explained why he chose to study economics under von Wieser:
“I was personally a pupil of [sc. Eugen von Böhm-Bawerk’s] … contemporary, friend and brother-in-law, Friedrich von Wieser. I was attracted by him, I admit, because unlike most of the other members of the Austrian school, he had a good deal of sympathy with a mild Fabian socialism to which I was inclined as a young man. He in fact prided himself that his theory of marginal utility had provided the basis of progressive taxation, which then seemed to me one of the ideals of social justice” (F. A. Hayek, “Coping With Ignorance,” July 1978; see also Hayek 1983: 17).
When Hayek studied under Friedrich von Wieser shortly before 1921, the latter was known to have “a good deal of sympathy with … [the] mild Fabian socialism” of Hayek’s youth.

These details are confirmed in the series of interviews with Hayek published in 1983 (see Nobel Prize-Winning Economist: Friedrich A. von Hayek, Regents of the University of California, 1983).

Hayek was asked about his student days:
BUCHANAN: Well, to go back to the Austrians again, were you actually a student of Bohm-Bawerk and Wieser?

HAYEK: No. Böhm-Bawerk, no. Böhm-Bawerk died in 1915, when I was sixteen. I happened to know him as a friend of my grandfather and a former colleague at [the University] of Innsbruck, and as a mountaineering companion of my grandfather’s. But when I saw him, I had no idea what economics was, because I was too young. I was a direct student of Wieser, and he originally had the greatest influence on me. I only met Mises really after I had taken my degree (Nobel Prize-Winning Economist: Friedrich A. von Hayek, p. 249).
When Hayek was asked about the history of the Austrian school in the 1920s, he gave this account:
LEIJONHUFVUD: In economics, let me come back to a question we have touched upon before. In the twenties in Vienna, was there such a thing as an Austrian school in economics? Did you and your contemporaries perceive an identification with a school?

HAYEK: Yes, yes. Although at the same time [we were] very much aware of the division between not only Meyer and Mises but already [Friedrich von] Wieser and Mises. You see, we were very much aware that there were two traditions—the [Eugen von] Böhm-Bawerk tradition and the Wieser tradition—and Mises was representing the Böhm-Bawerk tradition, and Meyer was representing the Wieser tradition.

LEIJONHUFVUD: And where did the line between the two go? Was there a political or politically ideological line involved?

HAYEK: Very little. Böhm-Bawerk had already been an outright liberal, and Mises even more, while Wieser was slightly tainted with Fabian socialist sympathies. In fact, it was his great pride to have given the scientific foundation for progressive taxation. But otherwise there wasn’t really—I mean, Wieser, of course, would have claimed to be liberal, but he was using it much more in a later sense, not a classical liberal (Nobel Prize-Winning Economist: Friedrich A. von Hayek, pp. 49–50).
In other words, there was a split in the Austrian school in the 1920s between (1) the classical liberal wing of Eugen von Böhm-Bawerk/Mises (which evolved into modern American libertarianism), and (2) the wing of von Wieser, whose members (or at least some of them) were leaning towards Fabian socialism, and was clearly becoming more like modern progressive liberalism or social democracy (see also Shearmur 1996: 29). According to Hayek, Friedrich von Wieser was proud of his work justifying progressive taxation – a viewpoint far indeed from modern American Austrians.

Hayek also confirms that socialist ideas were by no means confined to von Wieser in the 1920s/1930s Austrian school: another member who was apparently sympathetic to socialism was Richard von Strigl (1891–1942). Nor was classical liberalism/libertarianism the major or defining ideology in the discussion group called the “Geistkreis” that Hayek and J. Herbert Fürth founded in 1921:
LEIJONHUFVUD: Now, in the twenties, were most of the economists in Vienna at that time liberals in the traditional sense?

HAYEK: No, no. Very few. Strigl was not; he was, if anything, a socialist. Shams was not. Morgenstern—was not. I think it reduces to Haberler, Machlup, and myself.

LEIJONHUFVUD: So my previous question was: Was there an Austrian school? and you said yes, definitely.

HAYEK: Theoretically, yes.


HAYEK: In that sense, the term, the meaning of the term, has changed. At that time, we would use the term Austrian school quite irrespective of the political consequences which grew from it. It was the marginal utility analysis which to us was the Austrian school.

LEIJONHUFVUD: Deriving from Menger, via either Wieser or Bohm-Bawerk?

HAYEK: Yes, yes.

LEIJONHUFVUD: The association with liberal ideological beliefs was not yet there?

HAYEK: Well, the Menger/Bohm-Bawerk/Mises tradition had always been liberal, but that was not regarded as the essential attribute of the Austrian school. It was that wing which was the liberal wing of the school.

LEIJONHUFVUD: And the Geistkreis was not predominately liberal?

HAYEK: No, far from it.

LEIJONHUFVUD: And what about Mises’s seminar?

HAYEK: Again, not. I mean you had [Ewald] Schams and Strigl there; and Engel-Janoschi, the historian; and Kaufmann, who certainly was not in any sense a liberal; Schutz, who hardly was—he was perhaps closer to us; Voegelin, who was not ….

LEIJONHUFVUD: So in the revival of interest in the Austrian school that has taken place in recent years in the United States …

HAYEK: It means the Mises school (Nobel Prize-Winning Economist: Friedrich A. von Hayek, pp. 54–56).
Hayek gradually abandoned his earlier sympathy to Fabianism under the influence of Mises in the 1920s (Ebenstein 2003: 40–41), and the classical liberal strand of Austrian economics hostile to government intervention has become the only real modern form of the Austrian school. This classical liberal strand spread to America when Mises moved to New York in 1940, and as noted above it was this type that transmuted into American libertarianism.

But hostility to government was not the original essence of Austrian economics at all, and the school was divided on the issue of government intervention.

Here’s my advice for the next time you debate a libertarian who quotes Mises and Hayek: remind them that two of the first-generation founders of Austrian economics were Fabian socialists.


Richard Henry Tawney (1880–1962) was an English economic historian and Christian socialist, and famous for his book The Acquisitive Society (1920). He was professor of economic history at the London School of Economics (LSE) from 1931–1949, in much the same period as Hayek’s time at the LSE.

Tawney was an inspiration to many people who advocate social democracy or democratic socialism in the non-Marxist Western tradition.

Hayek was asked his opinion of Tawney and this is worth quoting:
ROSTEN: What about the others at the London School, such as Harold Laski, who were very much in the Fabian tradition, out of which you came, in one way or another?

HAYEK: Harold Laski, of course, at that time had become a propagandist, very unstable in his opinions. There were many other people whom I greatly respected, like old [Richard Henry] Tawney. I differed from him, but he was a sort of socialist saint, what you Americans call a dogooder, in a slightly ironic sense. But he was a man who really was only concerned with doing good—my Fabian socialist prototype—and a very wise man.
(Nobel Prize-Winning Economist: Friedrich A. von Hayek, p. 113).
Despite his condescending reference to Tawney as a “do-gooder,” Hayek was willing to refer to Tawney as a man who “was only concerned with doing good—my Fabian socialist prototype—and a very wise man.”

I can only say: how far has modern Austrian economics diverged even from Hayek. I cannot imagine a modern Austrian ever writing words like this.


Ebenstein, A. O. 2003. Friedrich Hayek: A Biography, University of Chicago Press, Chicago.

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

Hayek, F. A. von, 1983. Knowledge, Evolution, and Society, Adam Smith Institute, London

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

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

Schumpeter, J. and J. B. Achille Loria, 1927. “Obituary: Friedrich von Wieser,” Economic Journal 37.146: 328–335.

Schumpeter, J. A. 1997. Ten Great Economists (rev. edn), Routledge, London.

Shearmur, J. 1996. Hayek and After: Hayekian Liberalism as a Research Programme, Routledge, London.

Monday, October 18, 2010

Austrian Business Cycle Theory: Its Failure to explain the Crisis of 2008

The Austrian business cycle theory (ABCT) is a credit-based explanation of the business cycle used by Austrian economists. ABCT has, however, come in different forms and was developed over many years by Mises, Hayek, Rothbard and more recently by modern Austrians like Roger Garrison. It is not monolithic, and some Austrians like Israel M. Kirzner have even criticised Hayek’s development of ABCT as not entirely consistent with Mises’ exposition in 1912. Here are some of the major works by Austrians where different forms of the ABCT are expounded:
(1) The version of Mises in Human Action: A Treatise on Economics (Auburn, Ala., 1998), pp. 568–583.

(2) Hayek’s first version of ABCT in Prices and Production (London, 1931). After Nicholas Kaldor’s attack on it in “Capital Intensity and the Trade Cycle” (Economica n.s. 6.21 (1939): 40–66), Hayek had to re-write his theory.

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

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

(5) Gerald P. O’Driscoll and Mario J. Rizzo in The Economics of Time and Ignorance (Oxford, UK, 1985), pp. 198–213.

(6) More recent developments of ABCT, as in Roger Garrison’s Time and Money: The Macroeconomics of Capital Structure (London and New York, 2000).
It should be noted that ABCT is not monolithic. But the historical essence of the theory is fairly clear:
“ABCT is unique in including real capital goods among its elements in a manner which does not assume away their essential heterogeneity ... The theory demonstrates the connection between this structure of capital and monetary policy by way of Wicksell’s natural rate of interest theory and Mises’s integration of money into general economic theory” (Batemarco 1998: 216)
However, both Ludwig Lachmann and Joseph Schumpeter did not think that Hayek’s business cycle theory could be used to explain all business cycles (Batemarco 1998: 222). More importantly, Israel M. Kirzner has also made the following remarks on Hayek’s theory:
KIRZNER: I've never felt that the Hayekian business cycle theory was essentially Austrian. In fact, Mises, who was the originator of this whole idea in 1912, didn't see it as particularly Austrian either. There are passages where he notes that people call it the Austrian theory, but he says it's not really Austrian. It goes back to the Currency School and Knut Wicksell. It's certainly not historically Austrian. Further, I would claim that, as developed by Hayek, there are many aspects of it that are non-Austrian. I don't believe that to be an Austrian you have to buy into the Hayekian view of business cycles …. I think the way Hayek developed it was not quite consistent with the way Mises laid it out in 1912 (see “An Interview with Israel M. Kirzner,” Austrian Economics Newsletter, vol. 17.1, 1997).
Kirzner believed that Hayek’s own version of ABCT was “not quite consistent” with Mises’ own theory from his 1912 book The Theory of Money and Credit. So clearly we have to careful about which form of ABCT we are criticising.

In this post I will analyse what appears to me to be the most important form of ABCT: the form postulating distortions in the capital goods sector (for a good summary of this form of ABCT, see Garrison 1997: 23–27), and how this simply cannot be invoked as a serious or fundamental explanation of the US housing boom in the 2000s and financial crisis of 2008.

In his popular pamphlet Economic Depressions: Their Cause and Cure written in 1969, Rothbard sets out a form of ABCT which seems typical of the general form of it . He points to malinvestments in capital goods by businesses as the fundamental cause of recessions:
“And there is a third universal fact that a theory of the cycle must account for. Invariably, the booms and busts are much more intense and severe in the “capital goods industries”—the industries making machines and equipment, the ones producing industrial raw materials or constructing industrial plants—than in the industries making consumers’ goods” (Rothbard 2009 [1969]: 32–33).

“But what happens when the rate of interest falls, not because of lower time preferences and higher savings, but from government interference that promotes the expansion of bank credit? …. What happens is trouble. For businessmen, seeing the rate of interest fall, react as they always would and must to such a change of market signals: They invest more in capital and producers’ goods. Investments, particularly in lengthy and time-consuming projects, which previously looked unprofitable now seem profitable, because of the fall of the interest charge. In short, businessmen react as they would react if savings had genuinely increased: They expand their investment in durable equipment, in capital goods, in industrial raw material, in construction as compared to their direct production of consumer goods” (Rothbard 2009 [1969]: 32–33).

“The problem comes as soon as the workers … begin to spend the new bank money that they have received in the form of higher wages. For the time-preferences of the public have not really gotten lower; the public doesn’t want to save more than it has. So the workers set about to consume most of their new income, in short to reestablish the old consumer/saving proportions. This means that they redirect the spending back to the consumer goods industries, and they don’t save and invest enough to buy the newly-produced machines, capital equipment, industrial raw materials, etc. This all reveals itself as a sudden sharp and continuing depression in the producers’ goods industries. Once the consumers reestablished their desired consumption/investment proportions, it is thus revealed that business had invested too much in capital goods and had underinvested in consumer goods” (Rothbard 2009 [1969]: 34–35).
In this short book, Rothbard says nothing about reckless lending by banks to people for mortgages, nothing about asset bubbles, and nothing about financial crises. The crisis that Rothbard postulates begins with a bust in “producers’ goods industries.” Rothbard also discussed ABCT in Man, Economy, and State (2004 [1962]: 994–1008). In a most extraordinary passage in Man, Economy, and State, Rothbard says this:
“What happens, however, when the increase in investment is not due to a change in time preference and saving, but to credit expansion by the commercial banks? …. What are the consequences? The new money is loaned to businesses.110 These businesses, now able to acquire the money at a lower rate of interest, enter the capital goods’ and original factors’ market to bid resources away from the other firms. At any given time, the stock of goods is fixed, and the [new money is] … therefore employed in raising the prices of producers’ goods. The rise in prices of capital goods will be imputed to rises in original factors. The credit expansion reduces the market rate of interest. This means that price differentials are lowered, and … lower price differentials raise prices in the highest stages of production, shifting resources to these stages and also increasing the number of stages. As a result, the production structure is lengthened. The borrowing firms are led to believe that enough funds are available to permit them to embark on projects formerly unprofitable.

110 To the extent that the new money is loaned to consumers rather than businesses, the cycle effects discussed in this section do not occur. (Rothbard 2004 [1962]: 995–996).
After this, Rothbard (2004 [1962]: 996–1004) expounds ABCT in its usual form. But his footnote has profound significance: “[to] the extent that the new money is loaned to consumers rather than businesses, the cycle effects discussed in this section do not occur.” In other words, the mechanisms causing recession or depression as postulated by his version of ABCT did not occur if the money is mainly loaned to consumers! ABCT assumes that newly created credit money is mainly loaned out to businesses (causing malinvestments in capital goods), and not to consumers to a significant degree.

In this case, we can already see that Rothbard’s version of ABCT cannot be a serious explanation of the housing bubble in the 2000s and the financial crisis of 2008.

It is claimed by some that Austrians economists predicted the crisis, and while it is true that some Austrians correctly identified the housing bubble, they were hardly alone. J. Tempelman in the Quarterly Journal of Austrian Economics states
“[to] be sure, a financial crisis of sorts had also been forecast by many non-Austrian economists, such as Nouriel Roubini and Stephen Roach ... [William R. White] and other Austrians, on the other hand, were more precise in predicting that a crisis would be triggered by a collapse of an asset bubble, specifically the real estate bubble” (Tempelman 2010: 5).
The idea that Austrians were the only ones holding a “more precise” view just isn’t true. There were also heterodox and Post Keynesian economists who were just as “precise” as some Austrians in predicting a financial crisis caused by a housing bubble and excessive debt. The most obvious example is the Post Keynesian Steve Keen of the University of Western Sydney (Australia), who from 2006 was predicting a major financial crisis (see Steve Keen, “‘No-one saw this coming’ Balderdash!” July 15th, 2009,

Moreover, Dirk Bezemer, Professor of Economics at the University of Groningen (Netherlands), has also done a survey of economists and economic commentators trying to establish who predicted the crisis by looking at those with (1) a serious economic model that was used in analysis, (2) predictions that went beyond identifying the property bubble to the implications for the real economy, (3) predictions on the public record, and (4) correct estimates of the timing of the crisis (see Dirk Bezemer, “‘No One Saw This Coming’: Understanding Financial Crisis Through Accounting Models,” Groningen University, 16 June 2009). Here is Bezemer’s list:
Forecast date: 2005
Fred Harrison, UK, Economic commentator

Forecast date: 2006
Dean Baker, US, Co-director, Center for Economic and Policy Research (in August 2002, he also appears to have predicted the housing bubble);

Michael Hudson, US, Professor, University of Missouri;

Steve Keen, Australia, Associate professor, University of Western Sydney;

Jakob Brøchner Madsen, Denmark, Professor, Copenhagen University;

Robert Shiller, US, Professor, Yale University;

Nouriel Roubini, US, Professor, New York University;

Kurt Richebächer, US, Private consultant and investment newsletter writer;

Forecast date: 2007
Wynne Godley, US, Distinguished scholar, Levy Economics Institute of Bard College;

Eric Janszen, US, Investor and iTulip commentator;

Peter Schiff, US, Stock broker, investment adviser and commentator.
Now of these eleven commentators and economists:
(1) Five (45%) are Post Keynesians (Baker, Godley, Hudson, Keen, Sorenson);

(2) Two (18%) are basically maverick neoclassicals (Roubini and Shiller);

(3) Two (18%) are in the Austrian tradition (Richebächer and Schiff).

(4) One (Fred Harrison) calls himself as a Georgist (a follower of Henry George)

(5) One is a combination of Austrian and Post Keynesian (Janszen).
(on the classifications, see Barkley Rosser, J. “Did Heterodox Economists Do Better At "Calling It" Than Mainstream Ones? August 28, 2009).
So in other words eight (72%) of the eleven made accurate predictions about the bubble and crisis and were non-Austrians. The largest group (45%) were actually Post Keynesians.

The claim that Austrians were the only ones to predict the crisis of 2008 is pure nonsense. Moreover, just because some Austrians correctly called the housing bubble, it simply does not follow that ABCT has been vindicated. Many other economists from different schools also called the housing bubble and a financial crisis. Are we, for example, to say that because Fred Harrison correctly predicted a housing bubble that his actual Georgist economics is therefore proven right? This simply does not follow, nor does it follow that Austrian economics is correct, merely because some Austrians identified the housing bubble as Harrison did.

In 2001–2008, excessive debt and reckless lending to individuals in a system of ineffective financial regulation was a major factor. This has nothing to do with entrepreneurs making malinvestments in capital goods that shift output into the more remote future, as in ABCT.

In the housing bubble, loans were made to people who clearly were unlikely to pay them back. Debt was used bid up asset prices in property, allowing yet more debt (via refinancing) for purchasing of commodities (whether durable or non-durable). ABCT in the form examined above does not explain this process. Another fundamental factor in the crisis of 2008 was the emergence of exotic financial instruments like collateralised debt obligations (CDOs), including asset backed securities and mortgage backed securities.

When the housing bubble collapsed, defaults on mortgages rose, causing losses to investment banks and other financial institutions holding mortgage backed securities. The financial crisis of 2008 led to a freezing up of interbank lending and a liquidity crisis, which then went global. The resulting effects spread to the real economy severely exacerbating the US recession that had already begun in December 2007. This series of events is best explained by the Keynesian Hyman Minsky’s financial instability hypothesis.

ABCT in the form examined above with its emphasis on malinvestments in the real capital goods sector is not an even remotely relevant explanation of 2000s boom and bust, and the 2008 global financial crisis.


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

Cowen, T. 1997 Risk and Business Cycles: New and Old Austrian Perspectives, Routledge, London.

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

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

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

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

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

Hülsmann, J. G. 2001. “Garrisonian Macroeconomics,” Quarterly Journal of Austrian Economics, 4.3: 33–41.

Kaldor, N. 1939. “Capital Intensity and the Trade Cycle,” Economica n.s. 6.21: 40–66.

Kaldor, N. 1940. “The Trade Cycle and Capital Intensity: A Reply,” Economica n.s. 7.25: 16–22.

Kaldor, N. 1942. “Professor Hayek and the Concertina-Effect,” Economica n.s. 9.36: 359–382.

Kirzner, I. M. 1994. Classics in Austrian Economics: A Sampling in the History of a Tradition, William Pickering, London.

Lachmann, L. M. 1978.Capital and its Structure, S. Andrews and McMeel, Kansas City.

Mises, L. von, 1953, The Theory of Money and Credit (trans. H.E. Batson), J. Cape, London.

Mises, L. 1996 [1949]. Human Action: A Treatise on Economics (4th rev. edn), Fox and Wilkes, San Francisco.

Mises, L. 1998 [1949]. Human Action: A Treatise on Economics, Ludwig von Mises Institute, Auburn, Ala.

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

Rothbard, M. 2008 [1985]. What has Government done to our Money? Ludwig von Mises Institute, Auburn, Ala.

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

Schumpeter, J. A., 1939. Business Cycles (2 vols), McGraw-Hill, New York.

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

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

Tempelman, J. 2010. “Austrian Business Cycle Theory and the Global Financial Crisis: Confessions of a Mainstream Economist,” 13.1: 3–15.

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

Tuesday, October 12, 2010

Money: Is it Wealth?

The view that money is not wealth isn’t new. Adam Smith held this view:
“The great wheel of circulation [= money] is altogether different from the goods which are circulated by means of it. The revenue of the society consists altogether in those goods, and not in the wheel [= money] which circulates them” (Smith 1811: 202).
Thus money is not synonymous with wealth, and money cannot be consumed in the way that commodities can. There is a widespread belief that real wealth is goods and services available in a nation, though it is sometimes unclear whether this definition of wealth includes real assets like housing or commercial property.

Libertarians are fond accusing Keynesians of saying that “money is wealth” or that “money creation is wealth creation.”

This is, of course, a caricature. One can readily agree that money is not wealth. Money is (1) a unit of account, (2) a medium of exchange and (3) a store of value.

In this role, money is (1) a claim on output or (2) a future claim on output (commodities). However, money does have utility on its own account. People can desire to hold money as hedge against future uncertainty, but even here one can say that this is because of its store of value function that allows purchasing power to be used in the future.

Libertarians frequently invoke one aspect of Say’s law of markets which states that people need to engage in production before consumption. In other words, consumption of commodities must have prior production (at home or overseas). This is certainly true. What does not follow is that supply (total factor payments from production) will equal consumption or investment. Aggregate demand failures can in fact occur.

Now money is a unit of account and medium of exchange (also a store of value): but as a unit of account and medium of exchange it is a thing that facilitates exchange and production. One can agree that money itself is not wealth in the sense that is not identical with commodities, but is a claim on commodities.

In a recession, there are idle resources and capacity utilization has fallen. But the nation’s ability to produce things is not fundamentally impaired. Factories might be idle or running at 50% or 70% capacity with space for further production, and unemployment (idle labour) might be high.

Wealth creation done in the private sector is facilitated by Keynesian macroeconomic management of the economy, and in particular by ending recessions.

Deficit spending in a recession is a way of mobilizing idle resources like labour for creation of public infrastructure. Actual production (= wealth creation) is facilitated in the private sector by paying idle workers money as wages to allow them to consume from the private sector or by payment by government for other commodities from the private sector.

A similar process would occur even if the spending was done privately. For example, if a private businessman decided to build a railway in an area where it was needed, the money for the construction would came from a private loan, and the economic activity that resulted would increase private sector production through idle workers using money wages for consumption and the use of other commodities from the private sector in construction of the railway.

While deficit spending normally involves creation of public infrastructure and not factories or new capital goods directly, the use of idle resources and payment of wages increases demand for commodities. This process increases production (say, by raising capacity utilization) and leads to an expansionary phase of the business cycle where new business and factories are created to expand output.

A recession by definition means idle resources, lower capacity utilization, and unemployment. Deficit spending just puts those idle resources to work. Production increases in the private sector when orders come in, employment falls, people are free to buy what commodities they want by deciding on the basis of subjective valuation.

Far from thinking of money as “wealth,” Keynesians can easily conceive of money as the tool that facilitates production and creation of wealth. There is no contradiction here with the proposition that real wealth is only output.


I do not follow or endorse the economics of Henry George, but he had an interesting view of wealth that is worth discussing. I quote from a summary of how Henry George defined wealth in his book Progress and Poverty:
All material things produced by labor for the satisfaction of human desires and having exchange value. This means that wealth must have all of these characteristics:

1. Wealth is material. Human qualities such as skill and mental acumen are not material, hence cannot be classified as wealth.
2. Wealth is produced by labor. Land possesses all the essentials of wealth but one -- it is not a product of labor, therefore it is not wealth.
3. Wealth is capable of satisfying human desire. Money is not wealth; it is a medium of exchange whereby wealth can be acquired. Nor are shares of stock, bonds or other securities classifiable as wealth. They are but the evidences of ownership. None of these satisfy desire directly; if they are destroyed, the sum total of wealth is not decreased.
4. Wealth has exchange value.”
It is unclear how production of services fits into this, but it appears to me that a good many libertarians view wealth in a way similar to that of Henry George.


Montes, L. and E. Schliesser (eds), New Voices on Adam Smith, Taylor & Francis Ltd, Hoboken. 225

Smith, A. 1811. An Inquiry into the Nature and Causes of the Wealth of Nations (11 edn; vol. 1), Oliver D. Cooke, Hartford.