In his The Clash of Economic Ideas (2012), Lawrence White nicely captures the essence of the Austrian School of business cycles: “The Mises-Hayek theory was first and foremost a theory of the ‘upper turning point’; it aimed to explain why the cheap-credit boom must give way to bust…. The recession is a corrective period in which the needed readjustments take place. The firms that made nonviable investments must wind them down, perhaps go bankrupt, laying off workers and idling machines, leading to above-normal unemployment and unused capacity until those workers and machines are reabsorbed into more sustainable employment elsewhere. The more rapidly the economy adjusts wages and prices and reallocates resources, the shorter the recession will be.” (pp.76-77)
Hayek published in 1931. Criticism of his business-cycle model, inspired by Böhm-Bawerk’s capital theory, was increasingly vigorous with the persistence of the Great Depression. The cyclical lengthening and shortening of the structure of production, an unlikely cause of garden-variety recessions, cannot possibly account for the size and nature of employment-production variations in the dramatic 1930s collapse. However, a lesser ambition of the Austrian School, i.e., describing the role of unfulfilled expectations with respect to investment projects toward the end of credit expansions, is much more plausible and helps elucidate some recurring characteristics of periodic macro instability. That the evidence indicates that confidence-rooted modeling of investment expectations powerfully motivates acute instability provides common ground for Keynesian and the Austrian macrodynamics.
The more fundamental issue is that, given their shared market-centric general-equilibrium framework, Austrian and Early Keynesian models, even if combined, remain badly inadequate. Along with Keynes, Hayek had little that was both relevant and coherent to contribute on the speed or nature of labor-price adjustments in a contracting economy. More than a half-century after the Second Industrial Revolution introduced large-scale corporate forms to the production landscape, Austrian theorists still did not recognize that deflation could no longer restore competitive wages and that the misguided attempt to do so would inflict huge damage on economic welfare. As a result, they were unable to answer important stabilization questions, including why unemployment persists above its natural rate or, more generally, why adverse nominal disturbances induce involuntary job loss. By the 1930s, monetary-policy advice rooted in market-centric general-equilibrium modeling was, as it remains today, dangerous.
The most interesting, and today misunderstood, part of the familiar Austrian story is that Hayek eventually got it. He (1975, p.5) later apologized for his Depression-era stabilization advice, especially his opposition to monetary expansion to counter deflation, which he attributed to naïveté about the nature of labor pricing in increasingly specialized economies: “At that time [early 1930s] I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was incompatible with a functioning economy. Perhaps I should have even then understood that this possibility no longer existed.” Modern Austrian theorists must face up to the likelihood that Friedrich Hayek, if alive today, would be most comfortable working within the coherent analytic framework of the GEM Project.
Blog Type: Policy/Topical Chicago, Illinois