The Austrian Theory in Perspective by Roger W. Garrison
The four essays in this volume, each written by a major figure in the Austrian School of Economics,
set out and apply a distinctive theory of the business cycle. The span of years 1932 to 1970,
over which they appeared saw a dramatic waxing and then waning of the prominence both inside
and outside the economics profession of the Austrian theory. Gottfried Haberler wrote in his 1932 essay
that the theory is not so well known in this country as it deserves to be. Although Ludwig
When Ludwig von Mises offered no assessment in this regard in his essay, he remarked in 1943 about the effect of the theory's general acceptance on the actual course of the cycle, anticipating a key insight in the modern literature on rational expectations.
Then, in 1969, Murray and Rothbard could write without serious overstatement that a correct theory of depressions and of the business cycle would be a good example of this.
Then, in 1969, Murray and Rothbard could write without serious overstatement that a correct theory of depressions and of the business cycle does exist even though it is universally neglected in present-day economics.
What happened over the span of nearly 40 years to account for the rise and fall of this theory of boom and bust?
The simple answer, of course, is the Keynesian Revolution.
John Maynard Keynes's general theory of employment, interest, and money, which made its appearance
in 1936, produced a major change in the way that economists deal with macroeconomic issues.
A close look at some pre-Keynesian ideas can show why the Austrian theory was so easily
lost in the aftermath of the Keynesian Revolution.
A brief survey of the alternatives offered by modern macroeconomics will show why there
is a newfound interest in this bold Austrian theory.
First introduced by Mises in his Theory of Money and Credit 1912, the theory was originally
billed as the Circulation Credit Theory rather than as a uniquely Austrian theory.
Mises was very much aware of its multinational roots. The notion that the market process
can be systematically affected by a divergence between the bank rate of interest and the
natural rate came from Swedish economist Knut Miksel. The understanding that the process
so affected would have a self-reversing quality to it, Mises used the term counter-movements
in his earliest exposition, came from the British Currency School, whose analysis featured
International Gold Flows.
The uniquely Austrian element in Mises's formulation is the capital theory introduced by Carl Menger
and developed by Eugen von Boehm-Bawerk.
Mises showed that an artificially low rate of interest maintained by credit expansion
misallocates capital, making the production process too time-consuming in relation to
to the temporal pattern of consumer demand.
As time eventually reveals the discrepancy, markets for both capital goods and consumer
goods react to undo the misallocation.
The initial misallocation and eventual reallocation constitute the microeconomic foundations that
underlie the observed macroeconomic phenomenon of boom and bust.
Mises's theory was superior to its Swedish forerunner in that Vicksel was concerned almost
exclusively with the effect of credit expansion on the general level of prices.
It was superior to its British forerunner in that the currency school's theory applied
only when monetary expansion in one country outpaced that of its trading partners. Mises's
theory was applicable even to a closed economy and to a world economy in which all countries
are experiencing a credit expansion. The theory took on a more predominantly Austrian character
In the hands of F. A. Hayek, in the late 1920s and early 1930s, Hayek gave emphasis to the
Austrian vision of capital that underlies the business cycle theory by introducing a simple
graphical representation of the structure of production. He used right triangles that
The Change in Shape to Illustrate a Change in the Economy's Capital Structure
Hayek focused the analysis clearly on the relationship between the roundaboutness of
the production process and the value of the corresponding output.
The Hayekian triangles keep track of both time and money as goods in process make their
their way through the temporally sequenced stages of production.
His notion of a linear production process is highly abstract and overly simple in the
light of a fuller accounting of the fixed and circulating capital that actually characterizes
a capital-using economy.
However, these triangles feature an essential but often neglected dimension, the time dimension,
in the account of boom and bust. Alternative theories, in which consumption and investment
appear as two coexisting aggregates, can be seen as even more simplistic, to the point
Hopperler concludes his essay with an expression of concern about the complexity of the Austrian
theory, which he saw as a serious disadvantage, but the complexity in his judgment is inherent
in the subject matter, and hence is not a fault of the theory. Complexity is evident
in the two early essays, 1936 and 1932, in their organization and style of argument.
Both Mises and Haberler defend the theory against its critics and deal with various
misunderstandings. Mises, for instance, identifies Irving Fisher's inflation premium, which attaches
itself to the rate of interest as prices in general rise, only to say that this is not
what he is talking about. He is discussing instead another aspect of interest rate dynamics.
The real rate of interest rises at the end of the boom to reflect the increasing scarcity
of circulating capital after excessive amounts of capital have been committed to the early
stages of production processes.
Haberler takes great pains to refocus the reader's attention away from the general
price level and toward the relative prices that govern the vertical structure of production.
He distinguishes between absolute deflation and relative deflation, and between primary
and fundamental phenomena that characterize the downturn, and secondary and accidental
phenomena that may also be observed.
All these complexities plus still others involving such notions as the natural rate of interest
and the corresponding degree of roundaboutness of the production process are unavoidable in
a theory that features an inter-temporal capital structure.
The theoretical richness that stems from the attention to capital has as its negative counterpart
The Expositional Difficulties and Scope for Misunderstanding
Keynes offered the profession relief from all this by articulating, though cryptically,
a capital-free macroeconomics.
As Rothbard's discussion implies, all the thorny issues of capital theory were simply
swept aside.
An alternative theory that featured the playoff between incomes and expenditures left little
or no room for a capital structure.
Investment was given special treatment not because of its link to future consumption,
but because spending on investment goods is particularly unstable.
Uncertainties, which are perceived to be a deep-seated feature of market economies, dominate
decision-making in the business community and give play to psychological explanations
of prosperity and depression, and the notion that depression may be attributable to pessimism
on the part of the business community, suggests a need for central direction and policy activism.
Prosperity seems to depend upon strong and optimistic leadership in the political arena.
Relief from the complexities of capital theory together with policy implications that were
exceedingly attractive to elected officials gave Keynesianism an advantage over Austrianism.
An easy-to-follow recipe for managing the macroeconomy won out over a difficult-to-follow
theory that explains why such management is counterproductive. Tellingly, the later two
essays, 1969 and 1970, are as much about Keynesianism as about Austrianism. Rothbard and Hayek are
are trying anew to call attention to a theory that had been buried for decades under the
Keynesian avalanche. Rothbard deals with the Phillips curve, which purports to offer a
choice to political leaders between inflation and unemployment. Hayek deals with the wage-price
spiral, which had captured the attention of journalists and textbook authors for much
of the postwar era. The need for dealing critically with Keynesianism and with monetarism, while
at the same time reintroducing the key considerations from Capital Theory, meant that the Austrian
Theory of the Business Cycle was an even harder sell in the 1970s than it had been a half
century earlier. The offering of these four separate and distinct essays on the Austrian
The time theory carries the message that there is no single canonical version of the theory.
Our understanding of boom and bust is not based upon some path story to be told once
and for all time.
Rather, the theory allows for variations on a theme.
The market works, it tailors production decisions to consumption preferences, but production
takes time, and as the economy becomes more capital intensive, the time element takes
on greater significance.
The role of the interest rate in allocating resources over time becomes an increasingly
critical one.
Still, if the interest rate is right, that is, if the interplay between lenders and borrowers
is allowed to establish the natural rate, then the market works right.
However, if the interest rate is wrong, possibly because of central bank policies aimed at
growing the economy, then the market goes wrong.
The particulars of just how it goes wrong, just when the misallocations are eventually
are all dependent on the underlying institutional arrangements and on the particular actions
of policymakers and reactions of market participants.
The essays leave much scope for solving puzzles, for refining both theory and exposition, and
for applying the theory in different institutional and political environments.
One enduring puzzle emerges from the writings of several economists, including Haberler,
who once embraced the theory enthusiastically, but subsequently rejected it.
The key question, underlying the recantations, is easily stated, can the intertemporal misallocation
of capital that occurs during the boom account for the length and depth of the Depression?
Haberler provides one of the best answers to this question, one that is most favourable
to the Austrian Theory in his 1932 essay. The maladjustment of the vertical structure
of production, to use Haberler's own term, does not by itself account for the length
and depth of the Depression. Rather, this policy-induced change in the intertemporal
structure of capital is the basis for the claim that a crisis and downturn are inevitable.
The reallocation of resources that follows the downturn, which largely mirrors both qualitatively
The same policymakers who orchestrated the artificial boom may well behave ineptly when
When they see that the ultimate consequence of their policy is a bust, their failure to
stem the monetary contraction together with interventions by the legislature that prop
up prices and wages and strengthen trade barriers will make a bad situation worse.
All such complications, which play themselves out as a self-aggravating contraction, are
correctly identified by Haberler as secondary phenomena.
This term is not employed to suggest that these aspects of the depression are negligible,
or second order in importance.
It may well be, Haberler explains, that the secondary wave of depression, which is induced
by the more fundamental maladjustment, will grow to an overwhelming importance.
Though possibly overwhelming, the effects of the complications are still secondary in
in the sense of temporal and causal ordering.
The puzzle in all this emerges when we read Haberler's 1976 recantation of the Austrian
Theory, which echoed Lionel Robbins's heartfelt recantation of a few years earlier.
Mises refers to Robbins's 1934 book, The Great Depression, as the best analysis of
the actual crisis.
In 1971, Robbins wrote in his autobiography that this is a book which he would willingly
see forgotten. Drawing on Robbins' recantation, Habler offers the opinion that the real maladjustments,
whatever their nature, were completely swamped by vast deflationary forces, but rather than
suggest as he had earlier that these forces could easily have been induced by the more
for Fundamental Maladjustments, he simply attributes them to institutional weaknesses
and policy mistakes.
The astute reader will see Haberler's 1932 discussion of secondary phenomena as an insightful
and hard-hitting critique of the 1976 Haberler, and would see a similar relationship between
the 1934 Robbins and the 1971 Robbins.
In 1932, Haberler alluded to the economic earthquakes that Western countries had experienced.
He might have put the earthquake metaphor to further use in accounting for the relationship
between primary and secondary issues.
During the 1906 earthquake in San Francisco, for instance, fires broke out and caused much
more destruction than had been caused by the actual quaking of the earth.
Even so, the fire was a secondary phenomenon, the quake was the primary phenomenon.
The fact that the length and depth of the Great Depression are to be accounted for largely
in terms of secondary phenomena, then, does not weigh against our understanding that the
primary phenomenon was the quaking of the capital structure.
What accounts, then, for the recantation of these Austrian theorists and of several others,
including John R. Hicks, Nicholas Caldor, and Abba P. Lerner?
This puzzle remains to be solved.
Expositional difficulties derive largely from the fact that the capital-based macroeconomics
of the Austrian School, and particularly the Austrian Theory of the Business Cycle, are
foreign to modern economists whose training is exclusively in labour-based macroeconomics.
In today's profession, a given capital stock has become one of the defining assumptions
underlying the conventional macroeconomic relationships.
To allow capital to be a variable rather than a parameter is to change the subject matter
from macroeconomics to the economics of growth.
Further, modern economists tend to think of capital holistically in terms of stocks and
flows, which precludes any consideration of changes to say nothing of unsustainable changes
in the capital structure.
Gordon Tullock's bafflement at the Austrian theory is illuminating in this regard. Tullock
takes Rothbard's essay as canonical and explains why the Austrians are wrong about depressions.
This article, together with a comment by Joseph T. Salerno and reply by Tullock, merit careful
study. According to Tullock's understanding of the Austrian theory, the boom is a period
during which the flow of consumer goods is sacrificed so that the capital stock can be
At the end of the boom, then, the capital stock would actually be larger, and the subsequent
flow of consumer goods would be correspondingly greater.
Therefore, the period identified by the Austrians as a depression would instead be a period
marked by increased employment, labour as complementary to capital, and a higher standard
of living.
The stock-flow construction that underlies this line of reasoning does not allow for
for the structural unemployment that characterizes the crisis, much less for the complications
in the form of the Secondary Depression.
This exchange between Tellic and Salerno gives the modern student of Austrianism a good feel
for the challenge involved in the exposition of Austrian theory in an academic environment
unreceptive to a capital-based macroeconomics.
Capital-based macroeconomics is simply macroeconomics that incorporates the time element into the
basic construction of the theory.
Investment now is aimed at consumption later.
The interval of time that separates the employment of means and the eventual achievement of ends
is as fundamental a variable as are the more conventional ones of land and labour.
The Austrian theory features the time element by showing what happens when the economy's
production time, the degree of roundaboutness, is thrown out of equilibrium by policies that
override the market process.
Beyond this general understanding, as already suggested, the focus of particular expositions
vary in accordance with the historical and institutional setting.
The fact that each of the essays in this volume reflects its own time and setting does not
does not imply a myopia on the part of its author, rather, it suggests the versatility of the theory.
Writing in the early 1930s, for instance, Mises called attention to the flight into real values that characterizes a hyperinflation, such as the one experienced in Germany in 1923.
This lesson, though, transcends the insights into that particular historical experience.
Since over a period of years, capital has been misallocated by an accelerating credit
expansion.
There is no policy that avoids a crisis.
In the modern vernacular, there is no possibility of a soft landing.
Decelerating the expansion will cause real interest rates to rise dramatically as credit
becomes increasingly scarce, bankruptcies would follow.
Further accelerating the expansion will cause hyperinflation and a collapse of the monetary
system.
Mises is telling us, in effect, that the central bank can print itself into trouble, but it
cannot print itself out of trouble.
Writing in 1970, Hayek refers to the central bank's dilemma by suggesting that on the
eve of the crisis, the policymakers find themselves holding a tiger by the tail.
He gives play to the political and economic forces that were then dominant by relating
The final throws of the boom take the form of a dual between labor unions, which have
the political power to force wage rates higher, and the central bank, which can bring them
back down, in real terms, by accelerating the rate of inflation.
Although Hayek above all others is to be credited with shifting the focus of business cycle
theory from labor markets to capital markets, he offers few clues in this essay about disequilibration
in the intertemporal structure of production. Instead, he recognizes that the political and economic dynamics of the period have given special relevance to the problem, he even calls it the central problem, of wage determination.
The application of the Austrian theory of the business cycle in today's economy would give little play to the fear of hyperinflation or to the problem of a wage-price spiral.
The central problem today is chronic and dramatic fiscal imbalance.
Budget deficits rather than credit expansion are found to be the focus in any plausible
account of the effect of the government's macroeconomic policy on the economy's performance.
Still, the central bank figures importantly into this story.
The very potential for monetizing the Treasury's debt eliminates the risk of default, and thereby
puts the Treasury on a much longer leash than it would otherwise enjoy.
The problem of an artificially low rate of interest in earlier episodes is overshadowed
by the problem of an artificially low risk premium on government debt.
Although risk-free to the holders of Treasury securities, this black cloud of debt overhangs
the market for private securities, distorting the economy's capital structure and degrading
its performance generally.
There are some modern applications of the Austrian theory that take these considerations
into account, but much remains to be done.
A stock-taking of the modern alternatives to the Austrian theory suggests that capital-based
macroeconomics may be due for a comeback.
Conventional Keynesianism, whether in the guide of the principles level Keynesian cross,
the intermediate ISLM, or the advanced ASAD, is formulated at a level of aggregation too
too high to bring the cyclical quality of boom and bust into full view.
Worse, the development of these tools of analysis in the hands of the modern textbook industry
has involved a serious sacrifice of substance in favour of pedagogy.
Students are taught about the supply and demand curves that represent the market for a particular
good or service, such as hamburgers or haircuts.
They are then led into the macroeconomic issues by the application of similar looking supply
The Transition to Aggregate Supply and Aggregate Demand, which is made to look deceptively simple, hides all the fundamental differences between microeconomic issues and macroeconomic issues.
While these macroeconomic aggregates continue to be presented to college undergraduates, they have fallen into disrepute outside the classroom.
One recent reconsideration of the macroeconomic stories told to students identifies fundamental inconsistencies in ASAD analysis.
Conventional monitorism employs a level of aggregation as high as if not higher than that employed by Keynesianism.
While Milton Friedman is to be credited with having persuaded the economics profession and much of the general citizenry
In the theory of the strong relationship between the supply of money and the general level
of prices, his monetarism adds little to our understanding of the relationship between
boom and bust.
The monetarists have effectively countered the Keynesians on many fronts, but they share
with them the belief that macroeconomics and even business cycle theory can safely ignore
all considerations of a capital structure.
Modern spin-offs of monetarism, which incorporate the ideas of rational expectations and instantaneous
These market-clearing have brought the time element back into play.
Overlapping generations models, and particularly the time-to-build models, seem to have some
relationship to Austrian ideas, but the emphasis on the development of modelling techniques
over the application of the theory to actual episodes of Oum and Bast has greatly diminished
the relevance of this strand of macroeconomic thought.
In recent years, there has been an increasingly widespread recognition that modern macroeconomics
is in disarray. Today's textbooks and professional journals are replete with models that, while
impressive in their display of techniques, are profoundly implausible and totally inapplicable
to the world as we know it. The inadequacies of modern economics have caused some academicians
to wonder, if only facetiously, how far back do we have to go before we can start all over?
The essays in this volume provide a substantive answer to that question. We have to go back
about 60 years to a time when capital theory was an integral part of macroeconomics. We
have to go back to the Austrian School. A modernized capital-based macroeconomics can
compare favorably with any present-day rivals. Murray Rothbard's essay ends with an anticipation
of the Austrian revival, which actually began with his help in 1974. This volume is offered
in the spirit of Rothbard, and in the hope that the Austrians will have an increasing
influence in the years ahead on the development of business cycle theory.