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.

Friday, October 8, 2010

Economics and Ethics: A Brief Survey

In the previous post (see “Rothbard on Mises’ Utilitarianism: Why the Systems of Mises and Rothbard both Collapse”), I pointed out that Rothbard’s natural law theory is untenable, and once that is recognised his whole case for anarcho-capitalism also collapses. While I will publish a longer post soon refuting natural law and natural rights theory, I present here a brief introduction to ethics. This post was also published as a guest post on the Cynicus Economicus blog ( “Guest Article: Economics and Ethics,” May 4, 2009).

For a number of economic systems (e.g., libertarianism, free market economics, neo-liberalism, social democracy, democratic socialism, communism etc), in intelligent debate many people justify their preferred system as public policy by appealing to some ethical theory, to convince other people of the morality or superiority of their system.

The Austrians who follow the praxeological system of von Mises claim that economic science is value-free, and that the inferences of praxeology are justifiable as economic laws independently of ethics, though that remains a questionable idea. But, as a public policy prescription, even Austrians will often require an ethical theory, and Rothbard explicitly used natural rights theory to justify his anarcho-capitalism.

In the end, when an economic system is urged as a policy it must often be justified or limited by an ethical/moral theory, and one needs an objective theory of right or wrong to do this. For the only effective theories available to justify a larger philosophical system in a consistent way are objectivist theories of ethics (that is to say, a subjectivist or relativist theory of ethics is self-defeating).

In essence, an objectivist theory of ethics holds that:
– moral judgements are propositions that have an objective value, either true or false (e.g, “The unjustified killing of another human being is wrong”);
– the truth of a moral proposition remains true regardless of the subjective opinions of a person or the values of a different culture (e.g., “Slavery is wrong”);
– morality is not subjective or relative.
If we want an objectivist theory of our morality, we essentially have these options:
(1) Moral absolutism
(a) Divine Command Theory
(b) Categorical Imperative ethics (Kantian ethics)
(2) Moral Universalism (minimal/moderate moral realism)
(i) Deontological theories:
(a) Natural law theories (Plato and many Christian philosophers)
(b) Thomist ethics
(c) Pluralistic deontology, the non-absolutist ethics of W.D. Ross
(d) Human rights objectivism (Rawls)
(ii) Consequentialist theories:
(e) Utilitarianism (act utilitarianism; rule utilitarianism)
(f) Ayn Rand’s objectivism?
(3) Ayn Rand’s objectivism?
(4) Utilitarian Kantian Principle of James Cornman (this combines deontology and utilitarianism).
All of these objectivist theories of morality/ethics can be divided into two basic groups as follows:
(1) Deontological theories (= duty or obligation based morality): the basis of morality is duty and some acts are always right no matter what consequences they can cause (the best example of which is Kantian ethics or some forms of divine command theory; Kant famously said that it is always wrong to lie, no matter what the circumstances).

(2) Consequentialist theories: the basis of morality is the evaluation of the consequences of acts on people (the most famous such theory is Utilitarianism). The greatest happiness of the greatest number of people is one way of describing it.

(I will not address the question whether Ayn Rand’s objectivism is consequentialist or in a category by itself, since this is disputed.)
Use your intuition and find out whether you subscribe to (1) a duty-based ethical theory or (2) a utilitarian or consequentialist ethical theory by thinking about this moral problem:
A known murderer comes to you and asks to know where a person he wants to kill is, and you are aware of his desire to commit murder. Do you:

(1) Lie to protect the innocent person and say you do not know, or
(2) Tell the murderer where that person is in the knowledge that a murder may occur?
Decision (1) makes you a utilitarian, and (2) a believer of duty-based ethics. Immanuel Kant held that (2) is the moral course of action, since lying is always immoral, under all circumstances.

Ethics as Applied to Economics

Divine command theory is easily refuted: e.g., if god orders someone to commit genocide, then this suddenly becomes a “moral” action, because God has ordered it. Thus divine ethics turns out to be a subjective theory of ethics: what is moral and what is not actually depends, in the end, on the arbitrary whim of God, not the goodness of actions or their consequences. If God’s moral laws are not arbitrary, then there must be some independent, objective standard or method he uses to determine what is right and wrong. But, if there is an independent, objective standard, then it is this system that tells us what is right or wrong, not the commands of God. We could presumably use reason to apply the standard ourselves to discover what is right and wrong, without any need for instruction from God. (And Kantian ethics was in fact partly an attempt to create an objectivist ethics that could defend Christian morality, but remove this problem by basing morality on moral principles derived from human reason.)

Many libertarians rely on a natural law/natural rights theory of ethics.

Thus they often argue that state intervention is bad when it violates private property rights, and that this government action is always immoral, irrespective of the good or bad consequences that state intervention has or may have.

Natural law as a theory can be traced back to Plato, the ancient Stoics, and many Christian philosophers. (Contrary to popular belief, the most widely-held theory of ethics in the Middle Ages in Christian philosophy was the natural law theory, not the crude divine command theory.)

Natural law was famously attacked by the English utilitarian philosopher Jeremy Bentham as “nonsense on stilts.”

One of the main weaknesses of natural law theory is that its main historical justification was the belief in a “divine order” and a divinely-created human nature that makes us conform to “natural law.”

For Plato, the divine soul made human beings conform to the natural law of the universe. In ancient Stoicism, all humans had a divine reason given by the gods to make them adhere to divine “natural law.”

When natural law theory was taken up by Christian theologians, they simply substituted the Christian god for the gods of the Greek and Romans.

In the early modern period, rationalist European philosophers like Grotius tried to defend natural law theory by removing God and the previous supernatural justification for it.

However, in doing so, they destroyed the only convincing explanation for belief in natural law (Tawney 1998: xxv-xxvi).

Thus anyone who accepts an atheistic and naturalistic scientific view of the universe, and who rejects all religion, has no reason to believe in natural law or natural rights.

I would note here that just because we appear to have an innate sense of right and wrong, this does not provide us with an objective system of ethics. That some scientists believe they can identify an innate sense of right and wrong, which humans have evolved through social life in communities during our evolutionary history, does not mean that they have found an objectivist theory of morality that can function as a consistent, logical and universal system for justifying our moral choices, both now and in the past. The well-known fact that there is a vast chasm between what can be regarded as moral in one society and immoral in another demonstrates that, like our language faculty (which also has a biological basis), our innate moral intuition can lead to quite different systems of morality in different cultures in different times (just as our core language faculty leads to vastly different languages, with different words, grammar and syntax). For instance, in ancient Greece and Rome, the killing of unwanted children by exposing them (i.e., leaving them at crossroads or abandoning them at birth) was widely accepted. Human sacrifice and slavery were also widely practised in many ancient societies, and this was apparently perfectly compatible with the “innate moral sense of right and wrong” that ancient people had, although it is no longer accepted today.

Only an objectivist theory of morality can demonstrate that these things are immoral now and also immoral in the past. So it turns out the innate sense of right and wrong is not the same thing as an objectivist theory of morality.

Nor does appealing to “nature” give us any objective standard of right and wrong. For example, cannibalism is observed in many species: does this make cannibalism moral for humans? It certainly does not, and anyone who thinks so has committed the fallacy of appeal to nature, a fallacy of relevance.

I will note here too that a very good starting point for why natural law and natural rights are untenable is Kai Nielsen, “The Myth of Natural Law,” in S. Hook (ed.), Law and Philosophy: A Symposium, University Press, New York. 1963.

Also relevant is L. A. Rollins, The Myth of Natural Rights (Loompanics Unlimited, 1983), which is an attack on the natural rights theories of Rothbard and Ayn Rand.

It follows that all modern types of libertarianism or free market economics based simply on a “natural law” or “natural rights” foundation are severely flawed systems (e.g., the systems of Adam Smith or Murray Rothbard). There is no reason to believe that the “natural law” that justifies placing inviolable property rights at the centre of our modern political or economic systems has any validity whatsoever.

In my opinion, Kantian ethics has no real consequences for economics: it can be used to justify numerous economic systems and is fully compatible with social democracy. However, Kantian deontological ethics has severe problems.

A better ethical theory, in my view, is a modern form of utilitarianism called rule utilitarianism (which is quite different from its crude early form as advocated by Jeremy Bentham). Some libertarians or advocates of free market economics actually do use utilitarian arguments to justify their positions and economic systems, e.g., Ludwig von Mises (although Mises’ praxeology was an a priori system of deductive reasoning, independent of his utilitarianism), the earlier Friedrich von Hayek (Gregg 2003: 21–22), and Milton Friedman (Frederick 2002: 23). Thus anyone who uses a utilitarian argument to support ideas about economics will ultimately have to examine the good and bad effects of the policies they advocate.

In these theories, there is no reason in principle why state intervention could not be moral and successful. Any economic argument, then, essentially becomes an argument about empirical reality: the consequences of economic policy today and in the past. The good consequences of state intervention and social democracy fully justify these policies. Of course, philosophical objections have been raised to utilitarianism as well.

One solution may be that we should adopt James Cornman’s Utilitarian Kantian Principle of ethics: this (as I understand it) has caused a great deal of excitement amongst modern philosophers, because it combines the best elements of Kant’s deontological ethics with utilitarianism. It is perfectly compatible with state intervention in economics.


Marx himself, as I understand it, rejected the utilitarianism of his day for some very confused ideas on ethics (Alan Gilbert, Democratic Individuality, Cambridge University Press, 1990, p. 240). And, at the very least, the question of what ethical theory he believed in is debatable (N. Churchich, Marxism and Morality: A Critical Examination of Marxist Ethics, James Clarke & Co., 1994, p. 139).

Since I don’t advocate communism as preached in the Communist Manifesto, it has nothing to do with my moral argument for certain types of state intervention.

Furthermore, the means Marx advocated to achieve communism (i.e., dictatorship, destruction of freedom of speech and civil liberties) can be rejected on utilitarian grounds anyway, since the abolition of freedom of speech and dictatorship have harmful effects on everyone.


Cornman, J. W., Lehrer, K. and G. S. Pappas. 1992. Philosophical Problems and Arguments: An Introduction, Hackett, Indianapolis.

Frederick, R. 2002. A Companion to Business Ethics,, Blackwell, Malden, Mass.

Gregg, S. 2003. On Ordered Liberty: A Treatise on the Free Society, Lexington, Oxford and Lanham, Md.

Nielsen, K. 1963, “The Myth of Natural Law,” in S. Hook (ed.), Law and philosophy: A Symposium, University Press, New York.

Rollins, L. A. 1983. The Myth of Natural Rights, Loompanics Unlimited.

Scruton, R. 1994. Modern Philosophy: An Introduction and Survey, Penguin Books, London.

Tawney, R. H. 1998. Religion and the Rise of Capitalism, Transaction, New Brunswick, N.J. and London.

Rothbard on Mises’ Utilitarianism: Why the Systems of Mises and Rothbard both Collapse

In a previous post (see “Was Mises a Socialist?: Why Mises Refutes Himself on Government Intervention”), I reviewed the critique of Mises’s Human Action by George J. Schuller (1950; 1951) and his exchange with Rothbard (1951).

It appears that, after George J. Schuller’s (1951) reply to Rothbard, the latter realised that there was a devastating contradiction in Mises’ thought. In Rothbard’s book The Ethics of Liberty (first published in 1982), Rothbard makes a remarkable concession on government intervention:
“What can Mises reply to a majority of the public who have indeed considered all the praxeological consequences, and still prefer a modicum–or, for that matter, even a drastic amount—of statism in order to achieve some of their competing goals? As a utilitarian, he cannot quarrel with the ethical nature of their chosen goals, for, as a utilitarian, he must confine himself to the one value judgment that he favors the majority achieving their chosen goals. The only reply that Mises can make within his own framework is to point out that government intervention has a cumulative effect, that eventually the economy must move either toward the free market or toward full socialism, which praxeology shows will bring chaos and drastic impoverishment, at least to an industrial society. But this, too, is not a fully satisfactory answer. While many or most programs of statist intervention—especially price controls—are indeed cumulative, others are not. Furthermore, the cumulative impact takes such a long time that the time-preferences of the majority might well lead them, in full acknowledgment of the consequences, to ignore the effect.” (Rothbard 2002: 211–212)
Rothbard comes dangerously close to conceding that government intervention does not necessarily lead to chaos or socialism, just as Schuller (1951: 190) had argued. One might also note that Rothbard states that the “cumulative impact” of some intervention takes a long time, which makes his case even weaker. For example, how long does it take? (5 years? 10 years? 50? 100? 200?).

But Rothbard makes a perfectly valid point against Mises’ utilitarianism as well, and how Mises cannot possibly provide a convincing counterargument against state intervention once the cost and benefits are weighed and such interventions have been endorsed by democratic vote:
The point here is that Mises, not only as a praxeologist but even as a utilitarian liberal, can have no word of criticism against these statist measures once the majority of the public have taken their praxeological consequences into account and chosen them anyway on behalf of goals other than wealth and prosperity. Furthermore, there are other types of statist intervention which clearly have little or no cumulative effect, and which may even have very little effect in diminishing production or prosperity (Rothbard 2002: 213) ….

“Thus, while praxeological economic theory is extremely useful for providing data and knowledge for framing economic policy, it cannot be sufficient by itself to enable the economist to make any value pronouncements or to advocate any public policy whatsoever. More specifically, Ludwig von Mises to the contrary notwithstanding, neither praxeological economics nor Mises’s utilitarian liberalism is sufficient to make the case for laissez faire and the free-market economy. To make such a case, one must go beyond economics and utilitarianism to establish an objective ethics which affirms the overriding value of liberty, and morally condemns all forms of statism” (Rothbard 2002: 214).
The full implications of this passage are profound. Rothbard is rejecting Mises’ utilitarian case for laissez faire, and saying that Mises’ praxeology does not in itself allow any Austrian to advocate any public policy whatsoever. A Misesian cannot justify an economic policy as an actual public policy just because it can (allegedly) be shown to be an inference of praxeology.

So Rothbard abandoned Mises’ utilitarianism and instead made the case for anarcho-capitalism and laissez faire a moral issue, which could be justified by an objective moral theory. This was a fundamentally important difference between Rothbard and Mises.

Now Rothbard called himself an Aristotelian neo-Thomist, and held an objective natural law/natural rights view of ethics. He proceeded to make the case for a free market economy on objective moral grounds based on natural law (for example, his nonaggression axiom was justified by appealing to natural law).

So we can easily and totally refute Rothbard simply by showing his objective natural law/natural rights theory is untenable.

Frankly, that is not difficult. I will devote a larger post to it soon. Here philosophy of ethics is important, and there are very powerful arguments against the idea of natural law or natural rights, which even some libertarians accept (indeed Mises himself rejected natural law precisely because the case for it is utterly unconvincing). I will note here that one of the serious objections to natural law theory is that its main historical justification was the belief in a “divine order” and a divinely-created human nature that makes us conform to “natural law.” In the early modern period, rationalist European philosophers like Grotius tried to defend natural law theory by removing God and the previous supernatural justification for it. However, in doing so, they destroyed the only convincing explanation for belief in natural law (Tawney 1998: xxv-xxvi).

Anyone who rejects natural law has no reason to accept Rothbard’s ethics or his moral case for anarcho-capitalism derived from it. And, once the ethical case for Rothbard’s system is destroyed, that leaves Mises’ severely flawed system which must also be rejected, as it simply cannot provide any rational objection to intervention on moral or pragmatic grounds.

The case for the praxeological Austrian economics of Mises or Rothbard is a house built on sand.


Rothbard. M. N. 1951. “Mises’ ‘Human Action’: Comment,” American Economic Review 41.1: 181–185.

Rothbard, M. N. 2002. The Ethics of Liberty, New York University Press, New York, N.Y. and London.

Schuller, G. J. 1950. Review of Human Action: A Treatise on Economics by Ludwig von Mises, American Economic Review 40.3: 418–422.

Schuller, G. J. 1951. “Mises’ ‘Human Action’: Rejoinder,” American Economic Review 41.1: 185–190.

Tawney, R. H. 1998. Religion and the Rise of Capitalism, Transaction, New Brunswick, N.J. and London.

Thursday, October 7, 2010

The Myth of Say’s Law

Jean Baptiste Say (1767–1832) is credited with Say’s law or Say’s law of markets (“loi des débouchés”, in French), of which Walras’ law appears to be a modern neoclassical restatement. Although Say did not use the expression “law” to describe his views, his writings on this subject are to be found in A Treatise on Political Economy (or the Traité d’économie politique in French), Book 1, Chapter 15 (Say 1832: 132–140; the first edition of which was published in 1803) and in the Catechism of Political Economy (Say 1816: 103–105).

In modern formulations of Say’s law, there are two main variants of it:
(1) Say’s Identity
According to Baumol (1977: 146), this

“is the assertion that no one ever wants to hold money for any significant amount of time, so that, as a result, every offer (supply) of a quantity of goods automatically constitutes a demand for a bundle of some other items of equal market value.”

(2) Say’s Equality
Again, according to Baumol (1977: 146), Say’s Equality

“admits the possibility of (brief) periods of disequilibrium during which the total demand for goods may fall short of the total supply, but maintains that there exist reliable equilibrating forces that must soon bring the two together.”
The issue of what J. B. Say himself thought is complicated by the fact that there was more than one edition of his Treatise on Political Economy. The second edition was published in 1814 and has a revised version of Say’s law (Baumol 1977: 147), while in the first edition the law of markets is not so complete. It was only in the second edition of the Treatise on Political Economy (1814) that Say’s discussion is identifiable as a “form of a type of Say’s equality, i.e., supply and demand are always equated by a rapid and powerful equilibration mechanism” (Baumol 1977: 159).

A reading of the modern interpreters of the law of markets make it clear that by Say’s equality, Say did not mean that downturns in the business cycle cannot occur. Say was attempting to show that there could not be a general glut or general overproduction of all commodities, and that there could never be an overall shortfall in aggregate demand. Say’s view was compatible with the possibility of downturns caused by individual commodities being overproduced. That is, there could be specific but limited types of commodities where overproduction occurred relative to demand for those commodities. Say’s law of markets appears to be compatible with short-term gluts of specific commodities. As Steve Keen has argued:
“[sc. before Keynes] mainstream economics did not believe there were any intractable macroeconomic problems. Individual markets might be out of equilibrium at any one time – and this could include the market for labour or the market for money – but the overall economy, the sum of all those individual markets, was bound to be balanced” (Keen 2001: 189).
On the neoclassical and classical view, there could not be a downturn caused by an overall deficiency in aggregate demand: slumps were caused by sectoral imbalances/sectoral disequilibrium or by external shocks. Aggregate supply could never exceed aggregate demand (Kates 1998: 4–5).

John Maynard Keynes in the General Theory had this to say about Say’s law:
“From the time of Say and Ricardo the classical economists have taught that supply creates its own demand;—meaning by this in some significant, but not clearly defined, sense that the whole of the costs of production must necessarily be spent in the aggregate, directly or indirectly, on purchasing the product …. As a corollary of the same doctrine, it has been supposed that any individual act of abstaining from consumption necessarily leads to, and amounts to the same thing as, causing the labour and commodities thus released from supplying consumption to be invested in the production of capital wealth” (Keynes 1936: 18–19).
Keynes’ remark about the classical economists is correct (Baumol 1999: 200). For example, Adam Smith held these ideas:
“In all countries where there is tolerable security, every man of common understanding will endeavour to employ whatever stock he can command, in procuring either present enjoyment or future profit. If it is employed in procuring present enjoyment, it is a stock reserved for immediate consumption. If it is employed in procuring future profit, it must procure this profit, either by staying with him, or by going from him. In the one case it is a fixed, in the other it is a circulating capital. A man must be perfectly crazy who, where there is tolerable security, does not employ all the stock which he commands, whether it be his own, or borrowed of other people, in some one or other of those three ways.” (Smith 1811: 198).

“What is annually saved is as regularly consumed as what is annually spent, and nearly in the same time too; but it is consumed by a different set of people. That portion of his revenue which a rich man annually spends is, in most cases consumed by idle guests, and menial servants, who leave nothing behind them in return for their consumption. That portion which he annually saves, as for the sake of the profit it is immediately employed as a capital, is consumed in the same manner, and nearly in the same time too, but by a different set of people, by labourers, manufacturers, and artificers, who re-produce with a profit the value of their annual consumption. His revenue, we shall suppose, is paid him in money. Had he spent the whole, the food, clothing, and lodging, which the whole could have purchased, would have been distributed among the former set of people. By saving a part of it, as that part is for the sake of the profit immediately employed as a capital either by himself or by some other person, the food, clothing, and lodging, which may be purchased with it, are necessarily reserved for the latter. The consumption is the same, but the consumers are different” (Smith 1811: 240).
These passages are essentially an assertion of Say’s Identity (Baumol 1977: 158). Keynes also states:
“Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment” (Keynes 1936: 26).
This was perhaps a mischaracterization of Say’s actual ideas (Kates 1998; Keen 2001: 189–190). In this passage, Keynes was refuting the reformulation of Say’s law by John Stuart Mill and Alfred Marshall. Say did in fact acknowledge that downturns in the business cycle could happen. Baumol has even argued that
“Say and other writers recognized that the zero value of the sum of excess demands, or supply creates its own demand (“Say’s identity”), may not hold in the short run. Say’s passage in his Letters to Malthus … even suggests an explanation – a desire to hoard or, as we would now put it, a temporary excess demand for money. But they thought the market would fairly quickly and automatically restore equilibrium” (Baumol 1999: 201).
In other words, it appears that Say eventually partly though not fully understood what Keynes himself believed: changes in liquidity preference can cause insufficient demand and involuntary unemployment. Both Say and J. S. Mill in some writings even appear to have allowed that failures in aggregate demand can cause recession (Hollander 2005: 383-284).

However, the general view of Say and the 19th century classical economists seemed to be that recessions and involuntary unemployment could occur, but mainly by sectoral imbalances (though Hollander maintains that Say and Mill glimpsed that failures of aggregate demand might be involved), and that Say’s law of markets was the mechanism by which equilibrium was rapidly restored in a free market economy (Kates 1998: 14).

So what does all this prove? That Say’s law of markets is true? Hardly.

In fact, Keynes still refuted the version of Say’s law in J. S. Mill and Marshall, even if they did not understand Say properly.

And a careful examination of Say’s writings on demand and production shows that his reasoning is deeply flawed. A good starting point is this passage in Say’s Catechism of Political Economy (1816: 103–105):
On what does the vivacity of the demand depend?

On two motives which are—1st. The utility of the product, that is, the necessity the consumer has for it:—2nd. The quantity of other products he is able to give in exchange.

I conceive the first motive. As to the second it appears to me that it is the quantity of money that the buyer possesses which induces him to buy or not.

That is also true: but the quantity of money which he has, depends on the quantity of product with which he has been able to buy this money.

Could he not obtain the money otherwise than by having acquired it by products?


If he had received the money from his tenants?

His tenant had received it from the sale of part of the products to which the earth had contributed.

If he had received the interest of a capital lent?

The undertaker who employed that capital had received the money which he paid, on the sale of a part of the products to which his capital had concurred.

If the purchaser had obtained this money by gift or inheritance—?

The giver, or he from whom the giver had obtained it, had it in exchange for some product. In every case the money, with which any product is purchased, must have been produced by the sale of another product; and the purchase may be considered as an exchange in which the purchaser gives that which he has produced, (or that which another has produced for him), and in which he receives the thing bought.

What do you conclude from this?

That the more the purchasers produce, the more they have to purchase with, and that the productions of the one procure purchasers to the other.

It appears to me, that if the buyers only purchased by means of their products, they have generally more products than money to offer in payment.

Every producer asks for money in exchange for his products, only for the purpose of employing that money again immediately in the purchase of another product; for we do not consume money, and it is not sought after in ordinary cases to conceal it: thus, when a producer desires to exchange his product for money, he may be considered as already asking for the merchandise which he proposes to buy with this money. It is thus that the producers, though they have all of them the air of demanding money for their goods, do in reality demand merchandise for their merchandise (Say 1816: 103–105).
Say believed that any short-term glut in particular commodities would be quickly eliminated.

First, Say holds that buyers of commodities cannot obtain money except by having acquired it from the sale of other commodities. This is also expressed in A Treatise on Political Economy, Book 1, Chapter 15:
“A man who applies his labour to the investing of objects with value by the creation of utility of some sort, can not expect such a value to be appreciated and paid for, unless where other men have the means of purchasing it. Now of what do these means consist? Of other values of other products, likewise the fruits of industry, capital and land. Which leads us to a conclusion that may at first sight appear paradoxical, namely, that it is production which opens a demand for products” (Say 1832: 133).
Here Say is clear that only production of other commodities provides the money to pay for “products” (a related question is what he means by “capital”: if this means investment money then it is obvious that Say naturally thinks of money as a commodity too). A form of this idea is sometimes encountered on libertarian blogs. For example, one will find Austrians asking questions such as “how could people have money if they hadn’t produced something to exchange for money?”

The answer is that without production people would have no commodities (= wealth) for consumption. They might still have money. The premise of such a question is that without prior production there is no money to purchase commodities. This commits Austrians to the view that money is a “produced” commodity. But today we live in a fiat money world. Money is no longer “commodity” money. It is not “produced” in the way that gold and silver are dug out of the ground. Today fractional reserve banking creates money through debt, and open market operations create new money in the form of bank reserves. This is the real world in which we live, and even in Say’s own time fractional reserve banking was creating fiduciary media without prior creation of commodities.

Say’s law appears to require a world where money is produced like any other commodity, and this is one condition for the law of markets to work. But the condition does not exist today: Say’s law is irrelevant to modern fiat money using economies, where money also has a store of value role.

The second fatal and ridiculous flaw in Say’s argument is the belief that “every producer asks for money in exchange for his products, only for the purpose of employing that money again immediately in the purchase of another product.”

In fact, it simply isn’t the case that producers of commodities (whether individuals or businesses) or the recipients of the money profits of the firm like workers or owners will always use the money they earn from the sale of commodities “only for the purpose of employing that money again immediately in the purchase of another product.” Money can be saved and it can become idle. Capitalism also has markets for real and financial assets. Money can flow into the purchasing of financial assets. If there are financial assets or real assets whose prices are rising, modern capitalists, producers and even workers might decide to start speculating on asset prices. This would take money away from the purchasing of commodities and instead tie it up in exchanges on asset markets, as money alternates between being (1) held idle before buying assets and (2) purchasing assets, and then being held idle again by the new owner of the money in preparation for further speculation.

Another fatal flaw in Say’s reasoning is that money has no utility and cannot be used as a store of value:
“for we do not consume money, and it is not sought after in ordinary cases to conceal it” (Say 1816: 104).

“For, after all, money is but the agent of the transfer of values. Its whole utility has consisted in conveying to your hands the value of the commodities, which your customer has sold, for the purpose of buying again from you; and the very next purchase you make, it will again convey to a third person the value of the products you may have sold to others” (Say 1832: 133).

“Money performs but a momentary function in … double exchange; and when the transaction is finally closed, it will always be found, that one kind of commodity has been exchanged for another” (Say 1832: 134).

“When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus, the mere circumstance of the creation of one product immediately opens a vent for other products” (Say 1832: 134–135).
It is clear that Say believes in neutral money, and he is deeply mistaken in thinking of money only as a neutral “veil” with no store of value function (for the concept of neutral money, see Visser 2002). Say’s analysis also ignores the role of financial markets in affecting demand for money.

It should be noted of course that Say’s ideas were later developed by the Classical economists, so Say’s law in that historical sense is not the same as the ideas found in Say’s own writings.

So what was Say’s law in its developed form and as held by modern defenders of it?

Thomas Sowell (1994: 39–41) argues that in Classical economics Say’s law can be expressed by these propositions:
(1) The total factor payments received for producing a given volume (or value) of output are necessarily sufficient to purchase that volume (or value) of output [an idea in James Mill].

(2) There is no loss of purchasing power anywhere in the economy. People save only to the extent of their desire to invest and do not hold money beyond their transactions need during the current period [James Mill and Adam Smith].

(3) Investment is only an internal transfer, not a net reduction, of aggregate demand. The same amount that could have been spent by the thrifty consumer will be spent by the capitalists and/or the workers in the investment goods sector [John Stuart Mill].

(4) In real terms, supply equals demand ex ante [= “before the event”], since each individual produces only because of, and to the extent of, his demand for other goods. (Sometimes this doctrine was supported by demonstrating that supply equals demand ex post.) [James Mill.]

(5) A higher rate of savings will cause a higher rate of subsequent growth in aggregate output [James Mill and Adam Smith].

(6) Disequilibrium in the economy can exist only because the internal proportions of output differ from consumer’s preferred mix—not because output is excessive in the aggregate” [Say, Ricardo, Torrens, James Mill] (Sowell 1994: 39–41).
So this is Say’s law, according to the Classical economists.

First, it is perfectly possible that supply equals demand ex ante, which is asserted in proposition (1) and in the first statement in (4) (if one ignores the qualification “since each individual produces only because of, and to the extent of, his demand for other goods,” which does not follow at all), but to assert that it will always hold ex post is a non sequitur, without demonstrating the truth of propositions (2), (3), (5), and (6).

Unfortunately, these propositions cannot be held to be true.

Let’s start with proposition (2). Under conditions of uncertainty, money has utility (see my previous post “The Utility of Money in Post Keynesianism”, which I will use in what follows). It is deeply flawed to regard money only as a “neutral veil” that overcomes the inconveniences of direct barter. Such an idea is associated with the “neutral money axiom” (Davidson 2002: 19). In reality, people really do choose to hold money in and of itself as (1) a store of value and (2) a way of dealing with future uncertainty. Thus there is a precautionary motive for holding money, in addition to the transactions motive. Say’s law of markets requires neutral money or the idea that money only has a medium of exchange role. As Paul Davidson has argued,
“[in] an uncertain world, the possession of money and other nonproducible liquid assets provides utility by protecting the holder from fear of being unable to meet future liabilities” (Davidson 2003: 236).
The neoclassicals thought that only producible goods and services can provide utility. But money can have utility on its own account. So can liquid financial assets. The neoclassical view was that money has no utility, but only exchange value. The Austrian view also seems to be that money has no utility except for what can be obtained in exchange for it. The idea that money has no utility in itself is part of the three fundamental neoclassical axioms that Keynes rejected. The following three fundamental axioms are the basis of neoclassical economics and of Say’s law:
(1) the neutral money axiom (i.e., holding money by itself provides no utility),
(2) the gross substitution axiom, and
(3) the ergodic axiom.
If one assumes these false axioms, then one will believe that the “aggregate demand function is the same as the aggregate supply function” (Davidson 2002: 43). Post Keynesian economics requires the rejection of these axioms. In a fundamentally uncertain world, you have the problem of facing a possible lack of liquidity in the future (i.e., lack of money). This is why many people like to hold onto money, and precisely why money has utility – and in fact often has a great deal of utility.

Moreover, Keynes in the General Theory made the fundamental point that fiat money and even commodity money have special properties:
“… money has, both in the long and the short period, a zero, or at any rate a very small, elasticity of production, so far as the power of private enterprise is concerned, as distinct from the monetary authority;—elasticity of production meaning, in this context, the response of the quantity of labour applied to producing it to a rise in the quantity of labour which a unit of it will command. Money, that is to say, cannot be readily produced;—labour cannot be turned on at will by entrepreneurs to produce money in increasing quantities as its price rises in terms of the wage-unit. In the case of an inconvertible managed currency this condition is strictly satisfied. But in the case of a gold-standard currency it is also approximately so, in the sense that the maximum proportional addition to the quantity of labour which can be thus employed is very small, except indeed in a country of which gold-mining is the major industry.
Now, in the case of assets having an elasticity of production, the reason why we assumed their own-rate of interest to decline was because we assumed the stock of them to increase as the result of a higher rate of output. In the case of money, however—postponing, for the moment, our consideration of the effects of reducing the wage-unit or of a deliberate increase in its supply by the monetary authority—the supply is fixed. Thus the characteristic that money cannot be readily produced by labour gives at once some prima facie presumption for the view that its own-rate of interest will be relatively reluctant to fall; whereas if money could be grown like a crop or manufactured like a motor-car, depressions would be avoided or mitigated because, if the price of other assets was tending to fall in terms of money, more labour would be diverted into the production of money;—as we see to be the case in gold-mining countries, though for the world as a whole the maximum diversion in this way is almost negligible” (Keynes 1936: 230–231).
Money has a zero or very small elasticity of production. This means that a rise in demand for money and a rising “price” for money (i.e., an increase in its purchasing power) will not lead to businesses “producing” money by hiring workers.

The property of zero or very small elasticity of production also applies to liquid financial assets. If consumers decide to buy less producible commodities and increase their holding of money or ownership of financial assets, unemployment will result in some sectors as demand for commodities declines. The price of financial assets will rise and it is possible that the price of money could also rise. But private businesses cannot hire the unemployed to “produce” or “manufacture” more money or financial assets to exploit profit opportunities in the high-price liquid assets (Davidson 2010: 255–256).

In classical and neoclassical economics, however, money is held to be a commodity (e.g., gold, silver or some other type of commodity). If the demand for commodity money rises, neoclassical theory says it can be “produced” like any other commodity by hiring unemployed workers. But this idea is utterly false in a world where the commodity money consists of rare metals like gold or silver, and certainly false in the modern world of fiat money.

The second special property of money and liquid financial assets is that they have zero or near zero elasticity of substitution:
“The second differentia of money is that it has an elasticity of substitution equal, or nearly equal, to zero which means that as the exchange value of money rises there is no tendency to substitute some other factor for it;—except, perhaps, to some trifling extent, where the money-commodity is also used in manufacture or the arts. This follows from the peculiarity of money that its utility is solely derived from its exchange-value, so that the two rise and fall pari passu, with the result that as the exchange value of money rises there is no motive or tendency, as in the case of rent-factors, to substitute some other factor for it.
Thus, not only is it impossible to turn more labour on to producing money when its labour-price rises, but money is a bottomless sink for purchasing power, when the demand for it increases, since there is no value for it at which demand is diverted—as in the case of other rent-factors—so as to slop over into a demand for other things” (Keynes 1936: 231).

“money has (or may have) zero (or negligible) elasticities both of production and of substitution” (Keynes 1936: 234).
Financial assets are not gross substitutes for commodities. The neoclassical gross substitution axiom is wrong. In both a commodity money and fiat money world, savings are held in the form of money and non-producible financial assets. An increase in demand for money and non-producible financial assets and rising prices of such liquid assets will not spill over into a demand for relatively cheaper commodities, because the elasticity of substitution of money and liquid assets is zero or near zero (Davidson 2010: 256–257; Davidson 2002: 44–45; see also Hahn 1977: 31). Even if wages and prices were perfectly flexible, there could still be “leakages” in aggregate supply in the form of speculation on financial asset markets which would be “non-employment inducing demand” (Davidson 2010: 257; Hahn 1977: 37).

Thus a shortfall in aggregate demand is possible.

Moreover, there are other obvious leakages from the aggregate income arising from production that result in insufficient aggregate demand. There is no necessary reason why all the income will be spent on commodities in a particular time period, or even at all. Savings and changes in the rate of saving may happen.

Sowell’s proposition (3) above is also unacceptable. Classical advocates of Say’s law argued that saving would result in reasonably quick consumption or investment, but that simply does not follow. Money savings can become idle balances (“hoards,” in the terminology of Keynes). But even idle balances of money are not the only cause of a shortfall in demand. We can list the various “leakages” from aggregate income as described above, as well as some other ones, as follows:
(1) People desire to hold money as a hedge against future uncertainty (the “precautionary motive,” in Keynes’ theory), and since expectations are subjective such holdings can vary. In depressions or recessions, people may choose to hold more of their money as cash. In underdeveloped and pre-modern economies, hoarding can take the form of holding money physically outside of banks as cash or coin (Gootzeit 2003: 182). In the Great Depression, the rise in the hoarding of money was a significant factor, as it probably was in pre-1914 downturns in the business cycle (Wicker 1996: 144).

(2) As we have seen, even when people hold money either as individuals or as savings in financial institutions, not all the money will be invested in production of producible commodities (= goods and services). Money can be used to speculate on asset prices. New savings or a rise in savings can be diverted to purchasing of financial assets (or real assets) with the money used to buy such assets then flowing to other speculators, who buy new financial assets or hold money idle in the process of using it in further speculation on assets. Thus there is a “speculative demand” for money that can rise or fall.

(3) In modern economies where savings are held in demand deposits and saving accounts in banks, money is invested by banks themselves. But even here investment by banks will be subject to subjective expectations under uncertainty. In recessions or depressions when expectations are low, banks may simply choose to keep their depositors’ money as excess reserves or use it to buy financial assets on secondary markets. Thus even modern banks can “hoard” by reducing investment and leaving money in idle balances (at central banks or held in reserve for speculation on financial assets).

(4) Money income can be spent on imports causing a trade deficit, which in pre-fiat money days could result in a contraction of the money supply and deflationary pressures.

(5) A government might levy taxes and a run budget surplus without re-injecting that money back into the economy (and effectively destroying it).
Once propositions (2) and (3) of Say’s law above are shown to be false, propositions (4) and (5) collapse completely, and the idea that supply equals demand ex post cannot be possible.

For all these reasons, aggregate demand failures can cause recessions, whenever aggregate demand falls short of supply. Equilibrium will not result and is not necessarily a condition of free markets. Say’s law is a myth.


In his discussion of the introduction of labour saving machines, Say recognised that this would create short term unemployment, and in a footnote actually advocated public works spending by government:
“Without having recourse to local or temporary restrictions on the use of new methods or machinery which are invasions of the property of the inventors or fabricators a benevolent administration ran make prevision for the employment of supplanted or inactive labour in the construction of works of public utility at the public expense as of canals, roads, churches or the like …” (Say 1832: 87).
This must come as an embarrassing shock to Austrians who so frequently cite Say’s work with approval.


Reservation demand is defined as a type of demand in which producers or sellers of commodities hold their commodities off the market and refuse to sell them, because they expect higher prices in the future.

Reservation demand was never invoked by J. B. Say or other classical economists in defence of Say’s law, but one modern libertarian defence of Say’s law appears to use this concept.

As J. T. Salerno notes,
Rothbard (1993, pp. 350–56, 662–67) was the first to analyze the demand for money in terms of its exchange demand and reservation demand components. In 1913, Herbert J. Davenport … also clearly identified these two partial demands for money but ultimately failed to integrate them into an overall theory of the demand for money” (Salerno 2006: 40, n, 4).
Rothbard sets out the types of reservation demand in relation to commodities:
“The sources of a reservation demand by the seller are two: (a) anticipation of later sale at a higher price; this is the speculative factor analyzed above; and (b) direct use of the good by the seller. This second factor is not often applicable to producers’ goods, since the seller produced the producers’ good for sale and is usually not immediately prepared to use it directly in further production. In some cases, however, this alternative of direct use for further production does exist. For example, a producer of crude oil may sell it or, if the money price falls below a certain minimum, may use it in his own plant to produce gasoline. In the case of consumers’ goods, which we are treating here, direct use may also be feasible, particularly in the case of a sale of an old consumers’ good previously used directly by the seller—such as an old house, painting, etc. However, with the great development of specialization in the money economy, these cases become infrequent” (Rothbard 2004 [1962]: 253).
Rothbard (2004 [1962]: 755ff.) treats money as a commodity and analyses the supply and demand for it “in terms of the total demand-stock analysis” he had used in Chapter 2 of Man, Economy, and State, and this obviously has relevance to Say’s law, and is indeed applied to it in Hoppe, Hulsmann, and Block (1998: 40).

To see how the concept of reservation demand is applied to money we can turn to Rothbard’s Man, Economy, and State: A Treatise on Economic Principles (1962):
“When a seller keeps his stock instead of selling it, what is the source of his reservation demand for the good? We have seen that the quantity of a good reserved at any point is the quantity of stock that the seller refuses to sell at the given price. The sources of a reservation demand by the seller are two: (a) anticipation of later sale at a higher price; this is the speculative factor analyzed above; and (b) direct use of the good by the seller. This second factor is not often applicable to producers’ goods, since the seller produced the producers’ good for sale and is usually not immediately prepared to use it directly in further production” (Rothbard 2004: 253).
So, in relation to commodities, Rothbard’s definition is in line with the generally accepted definition. But there is absolutely no necessary reason at all why (1) the value of commodities not sold due to reservation demand would equal (2) the total value of unsold commodities in a given period. Many commodities will remain on the shelves simply because they were not sold.

Moreover, Rothbard treats money as a commodity since he is an advocate of the gold standard. When we come to money, Rothbard also uses the concept of reservation demand:
“The total demand for money on the market consists of two parts: the exchange demand for money (by sellers of all other goods that wish to purchase money) and the reservation demand for money (the demand for money to hold by those who already hold it)” (Rothbard 2004: 759).

“More important, because more volatile, in the total demand for money on the market is the reservation demand to hold money. This is everyone’s post-income demand. After everyone has acquired his income, he must decide, as we have seen, between the allocation of his money assets in three directions: consumption spending, investment spending, and addition to his cash balance (‘net hoarding’). Furthermore, he has the additional choice of subtraction from his cash balance (‘net dishoarding’). How much he decides to retain in his cash balance is uniquely determined by the marginal utility of money in his cash balance on his value scale. … We have now to look at the remaining good: money in the cash balance, its utility and demand. Before discussing the sources of the demand for a cash balance, however, we may determine the shape of the reservation (or ‘cash balance’) demand curve for money” (Rothbard 2004: 759).
Rothbard’s reference to everyone acquiring “his income” can presumably refer to total factor payments from production (aggregate supply). Rothbard now defines “reservation demand” for money as the money flowing into cash balances (net hoarding).

It is here that libertarians might jump on Rothbard’s analysis to argue that Say’s law can be saved from collapse by applying the concept of reservation demand to money.

But what can the expression “reservation demand” mean when applied to money? When applied to commodities, it means that commodities are held off the market by sellers in expectation of higher prices in the future. Logically, then, reservation demand for money would be holding money in expectation of a higher price for money in the future in terms of its purchasing power. That is, a higher price for money can only mean a rise in money’s purchasing power, whether through general price deflation or falls in the prices of a commodity or commodities one wishes to purchase. Rothbard’s other comments support this:
“an expectation of a rise in the … [purchasing power of money] in the near future will tend to raise the demand-for-money schedule as people decide to “hoard” (add money to their cash balance) in expectation of a future rise in the exchange-value of a unit of their money. The result will be a present rise in the [purchasing power of money]” (Rothbard 2004: 768).
But Rothbard’s definition of “reservation demand” as all net money added to and held in cash balances (“net hoarding”) includes forms of idle money that cannot legitimately be called “reservation demand.” Rothbard has changed the meaning of “reservation demand” in a sleight of hand.

At most, “reservation demand” for money can only describe one subcategory of Keynes’ speculative demand for money: that category that involves holding money in expectation of general price deflation or price falls in one or other commodities.

Speculative demand for money includes many other categories, including holding money to buy assets expected to rise in price in the future.

And even if one chooses to make “reservation demand” for money in its only proper sense equal to its value as inserted into aggregate supply, this still leaves other idle money balances not spent on consumption or investment in capital goods.

A revised version of Say’s law according to the libertarian defence can be given here:
Aggregate supply (AS) = total factor payments + value of money held in reservation demand
Aggregate demand (AD) = consumption + investment on capital goods + value of commodities and money in reserve demand.
This still does not save Say’s law. Although the value of all commodities held by “reservation demand” equals the value of such commodities included in total factor payments, there will still be the value of commodities not purchased by consumption or investment on capital goods in AD left over.

As for AD, the value of total factor payments will be divided into these three categories when spent in aggregate demand:
(1) consumption payments;
(2) investment on capital goods;
(3) money held by reservation demand (a speculative demand for money);

But money from total factor payments can also be diverted into

(4) money held idle by precautionary motive (money held because of uncertain future);
(5) money held for other speculative demands;
(6) money held idle in financial market transactions.
Although money held in (3) will by definition equal money held in reservation demand in aggregate supply, there is still the likelihood that money will be held idle by the precautionary motive (4), other speculative demands (5), and in financial market transactions (6).

Rothbard’s sleight of hand is to lump (3), (4), (5), and (6) into one category he called reservation or ‘cash balance’ demand.

This can be used to then argue that Say’s law holds because the category “cash balance demand” is by definition equal to that value in aggregate supply when it is inserted into AS.

But this trick will not save Say’s law. In (3), (4), (5), and (6), money will be idle and not spent on aggregate supply. Without total factor payments going to purchase commodities or to capital goods investment, aggregate demand failures can occur.

I also note that Hoppe, Hulsmann, Block, in response to Selgin and White (1996), have also used the concept of reservation demand in discussing Say’s law and in arguing against the existence of fiduciary media:
“[Selgin and White] have overlooked Say’s law: all goods (property) are bought with other goods, no one can demand anything without supplying something else, and no one can demand or supply more of anything unless he demands or supplies less of something else. But this is here not the case whenever a fiduciary note is supplied and demanded. The increased demand for money is satisfied without the demander demanding, and without the supplier supplying, less of anything else. Through the issue and sale of fiduciary media, wishes are accommodated, not effective demand. Property is appropriated (effectively demanded) without supplying other property in exchange. Hence, this is not a market exchange which is governed by Say’s law – but an act of undue appropriation” (Hoppe, Hulsmann, Block 1998: 40).
One obvious consequence of such a view is that Say’s law can only hold in a world without fiduciary media, fractional reserve banking and fiat money! For Say’s law to work in the way postulated here there must only be commodity money and no fractional reserve banking or fiduciary media. We don’t live in such a world, so Say’s law does not hold.


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