Rethinking Capital Based Macroeconomics - Adrian Ravier

8/3/2019 Rethinking Capital Based Macroeconomics - Adrian Ravier

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348 The Quarterly Jurnal f Austrian Ecnmics 14, N. 3 (2011)

RETHINKING CAPITAL-BASED MACROECONOMICS

Roger Garrison was the rst Austrian economist to model theprcess f capital frmatin and the distrtin f marketprcesses by mnetary plicy, which he illustrated by means fa series f interrelated graphics in his Austrian Macroeconomics: ADiagrammatical Exposition , published in 1978. He used HayekianTriangles representing the inter-tempral structure f prductinand Rthbards Aggregate Time Market representing the

relatin between present and future gds t illustrate changes inaggregate time preference and interest rate determinatin. Even inthis, his rst attempt, Garrison demonstrated the models potentialas a means f evaluating alternative ecnmic dctrines, usingAustrian Ecnmics and Keynesianism as an example.

over the next twenty years Garrisn wrte numerus articlesn this theme, many f which were published in mainstreammacrecnmic jurnals. In the prcess he develped his wn

versin f the Austrian thery f capital and the business cycle twhich Richard Cantilln, David Ricard, Carl Menger, Eugen vnBhm Bawerk, Knut Wicksell, Ludwig vn Mises, Friedrich A. vnHayek, Richard vn Strigl, Murray Rthbard and Mark Skusen,amngst thers, had cntributed.

The results f this prcess were published as Time and Money: TheMacroeconomics of Capital Structure (Garrisn 2001).1 The bjectivesf this bk were (1) t express capital thery in such a way that its

implicatins fr market prcesses in bth the shrt- and lng-termare evident, and (2) t help reintegrate capital int macrecnmics,and macrecnmics int mdern Austrian ecnmics.

1 We can see that these tw dimensins (time and mney) were in Garrisns mindalmst twenty years befre he published the bk. In Austrian Macroeconomics:A Diagrammatical Exposition (Garrisn 1978, p. 169) he wrte: one f the mstdistinctive features f Austrian macrecnmic thery is the cncept f thestructure f prductin. This cncept was frmulated t give explicit recg-nitin t the ntin that capital (and the capital structure) has tw dimensins.

It has bth a value dimensin which can be expressed in monetary terms , anda time dimension which is an expressin f the time that elapses between theapplicatin f the riginal means f prductin (labr and ther resurces)and the eventual emergence f the cnsumptin gds assciated with them.(Emphasis added.)


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depressin, we start frm an unemplyment situatin t explainwhy expansinary mnetary plicies fail t reslve this cnditinin the lnger run.

It shuld be acknwledged that this big questin is nt newin the Austrian literature. After his Prices and Production (1931)had been criticized fr failing t address the unemplyment fresurces Hayek himself cnsidered the questin in Prots, Interestand Investment (1939, p. 5):

We shall start here frm an initial situatin where cnsiderable unem-plyment f material resurces and labur exists, and we shall takeaccunt f the existing rigidity f mney wages and f the limitedmbility f labur. [...] The earlier presentatin f essentially the sameargument in Prices and Production has been frequently criticised fr itsfailure t take accunt f the existence f unused resurces. It still seemsto me that to start rst from a position of equilibrium was logically theright prcedure, and that it is imprtant t be able t shw hw frm suchan initial position cyclical uctuations may be generated. But this oughtto be supplemented by an account of how such cyclical uctuations, once

started, tend t becme self-generating, s that the ecnmic system maynever reach a psitin which culd be described as equilibrium. ThisI shall try t d here and I hpe t shw that t intrduce these mrerealistic assumptins strengthens rather than weakens my argument.

our bjective is t use an extensin f Garrisns framewrk tillustrate the validity f Hayeks argument. This issue is f particularinterest in the cntext f recent recurse t quantitative easing.We als advance the argument that by extending Garrisns wrk

t include recent develpments in capital-based macrecnmicsur mdel sheds light n the debate between Hayek and Keynesthat tk place in the 1930s.

our starting pint is Salerns (2001, p. 45) warning that

It is crucial t get the analytics right frm the very start. In particular, it isessential t carefully scrutinize Garrisns analytical apparatus t ensurethat it des nt implicitly assume any causal relatinship that cntradictsthe underlying verbal-lgical therems that it is built upn.

We adpt the unemplyment case with this cautin in mind. Thisextensin is advantageus fr tw main reasns: 1) it facilitates amre direct cntrast with the Keynesian apprach, and 2) it bth


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351Adrin o. Ravier: Rethinking Capital-Based Macrecnmics

requires and permits explicit treatment of the non-neutrality eect,which we believe was nt feasible in the riginal framewrk.

Part I utlines the riginal mdel as it was presented in Time andMoney (2001). Part II proposes a modication of the model whichallws us t answer a questin Garrisns capital-based macr-ecnmics culd nt address. Part III presents the implicatinsof this modication. Part IV concludes with a tabular summarycomparing the original model with our modication.

PART I: THE ORIGINAL MODEL

Understanding the market prcess that translates a change inintertempral preferences int a reshaping f the ecnmys inter-tempral structure f prductin, is a prerequisite t understandingthe business cycle, r mre narrwly, bm and bust, is hwGarrisn (2001, p. 67) pens his sectin n ecnmic cycles. Hwever,here we ignre his cntributin t capital frmatin in rder tcncentrate entirely n his explanatin f unsustainable bms andits implicatins fr Austrian business cycle thery (ABCT).


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Figure 1. Capital-Based-Macroeconomics

Consump-tion

C0

T0

I0

i0

I0;S0

S0

D0

Investment

InterestRate

Saving = Investment

Time or Stages in theProduction Process

Market forLoanable Funds

HayekianTriangles

ProductionPossibilitiesFrontier (FPP)

Garrisns framewrk uses the three main tls illustrated inFigure 1. The rst is a Market for Loanable Funds,2 a main-stream tl whichin Figure 2demnstrates the impact f theCentral Banks mnetary plicy when it lwers the market interestrate belw its natural level (t brrw Wicksells terminlgy)

and thereby causes savings and investments t diverge (Garrisn,2001, pp. 6970).

Frm the perspective f the entrepreneur, this created creditis indistinguishable frm savings, as Ludwig vn Mises explained(1949, pp. 433434). Credit creatin therefre results in mal-investment in the sense that prjects that wuld nt have beencnsidered in the absence f a credit creatin plicy nw prceed.

2 As already mentioned, in his rst attempt to develop a model, Garrison (1978)

used the Aggregate Time Market assciated with Rthbard (1962, p. 332) insteadf the Market fr Lanable Funds. This is nt the place t elabrate n this, but itis likely that the riginal tl was better suited t cnveying the Austrian message,since it represents mre accurately hw the time preference f individuals withrespect t present and future gds determines the rate f interest.


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This eect is observed in the second of the tools: the ProductionPssibilities Frntier (PPF). Withut any increase in savings, theecnmy attains higher levels f cnsumptin and investment,which is represented by a shift f the PPF upward and t the rightin Garrisns mdel. He explained that such a shift implies ver-cnsumptin and over-investment. This displacement is unsus-tainable because it is nt supprted by vluntary savings. Garrisnrepresented the PPF with a dtted line fr this reasn.

The crucial element f the mdel is the third tlthe Hayekian

Triangleswhich simply represents the inter-tempral structuref prductin. In Figure 2, the hrizntal and vertical expansinf the Hayekian Triangles represent the ver-cnsumptin andmal-investment which take place as a cnsequence f the creditexpansin plicy adpted by the mnetary authrity. Garrisn(2001, p. 72) bserves:

Figure 2. Shrt-Ru Eects f the Credit Expasi


HayekianTriangles


Consump-tion

C0

C1

T0

I0

I1

i0

i1

I0;S0 I1

S0 S0+M1

D0

Investment

InterestRate

Saving = Investment


In eect, the Hayekian Triangle is being pulled at both ends (by cheap

credit and strng cnsumer demand) at the expense f the middlea


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tell tale sign f the bms unsustainability. our tw incmplete anddierentially sloped hypotenuses bear a distinct relationship to theaggregate supply vectr and aggregate demand vectr suggested byMark Skusen (1990, p. 297) and are cnsistent with the expsitinprvided by Linel Rbbins ([1934] 1971, pp. 3043) and MurrayRthbard ([1963] 1972, pp. 1139).

However, these are only the short-run eects. In the long run,the eects are reversedas illustrated in Figure 3which is whyGarrisn calls it the thery f the unsustainable bm.

Garrisn therefre cncludes:

In sum, credit expansin sets int mtin a prcess f capital restruc-turing that is at dds with the unchanged preferences and hence isultimately ill-fated. The relative changes within the capital structurewere apprpriately termed malinvestment by Mises. The brken line inthe upper reaches f the less steeply slped hyptenuse indicates that therestructuring cannt actually be cmpleted. The bm is unsustainable;the changes in the intertempral structure f prductin are self-defeating. Resurce scarcities and a cntinuing high demand fr current

cnsumptin eventually turn bm int bust (2001, p. 72).


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Figure 3. Lg-Ru Eect f Expasiary Metary Plicy


HayekianTriangles


Consump-tion

C0

C1

C2

T0T1 T2 I0I2 I1

i0

i2

i1

I0;S0I2;S2 I1

S0

S2S0+M1

D0

Investment

InterestRate

Saving = Investment


Garrisns graphic treatment f credit expansin therefreconrms the outcome Ludwig von Mises anticipated in his Theoryof Money and Credit:

Certainly, the banks wuld be able t pstpne the cllapse; but never-theless, as has been shwn, the mment must eventually cme whenno further extension of the circulation of duciary media is possible.

Then the catastrphe ccurs, and its cnsequences are the wrse and thereactin against the bull tendency f the market the strnger, the lngerthe perid during which the rate f interest n lans has been belw thenatural rate f interest and the greater the extent t which rundabutprocesses of production that are not justied by the state of the capitalmarket have been adpted (1953, pp. 365366).

Garrisn uses the Market fr Lanable Funds t demnstratethat the interest rate rises when the mnetary authritiesperhaps

fearing an upsurge in inationdecide to restrict credit. Therise in interest rates makes it impssible t cntinue investmentprjects initiated during the easy mney interlude. At this pint,ver-cnsumptin and ver-investment are evident, illustrated as


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a retrenchment f the PPF t a pint below its riginal psitin,indicating a level f unemplyment exceeding the status quoante. The Hayekian Triangles cntract hrizntally and vertically,representing the excessive destructin f capital caused duringthe articially stimulated business cycle. Garrison also shows theeect on employment and wages, with unemployment higher andreal wages lwer than they were at the beginning f the prcess.

PART II: RETHINKING CAPITAL-BASED MACROECONOMICS

In an interview, Garrisn (2000) claimed his mdel was anattempt to defeat the Keynesians at their own game. In eect,his mdel is an attempt t develp an alternative t the Investmentand Savings, Liquidity Preference and Mney Supply (ISLM)mdel develped by Hicks, and subsequently elabrated byMundell-Fleming.3

Hwever, Jhn Maynard Keynes never cncerned himself withthe causes of the Great Depression that aicted both the Americanand British ecnmies. Instead he sught t identify ecnmicplicies which wuld allw these ecnmies t recver frm sucha Depressin. By the time f his Treatise on Money (1930), Keyneshad already abandned speculatin n equilibrium and fullemplyment t analyze the real wrld, ne in which savings andinvestments are nt always equal. He expressed his dubts that

3 In a sense, Garrisn cmpletes the wrk that Hicks suggested. Jhn Hicks (1967,pp. 204205) ntes that [s]everal f us made attempts at that translatin; thejurnals f the 1930s are full f them. But what emerged, when we tried t put theHayek thery int ur wn wrds, was nt Hayek. There was sme inner mysteryt which we failed t penetrate. In cntrast, Hicks (1937) himself was able tmathematize Keynes framewrk almst immediately in what tday is knwn asthe IS-LM model, work valued by Hayek (1995) as a signicant contribution to themst pressing questin f the day. Bruce Caldwell adds that [a]s the frmalisticrevlutin prgressed, mdels like Hayeks became curius antiquities. See the

intrductin that Caldwell wrte n the Hayek versus Keynes debate (1995, p.33). Hence the relevance f Garrisns cntributin: althugh it des nt advancemathematical develpment f the ideas f Hayek, it des express simply andcnsistently in the frm f graphs the cntrversy that dminated ecnmicthinking in the early years f the 1930s.


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the market alone could coordinate market processes suciently torestre equilibrium between savings and investment.

Need we be fatalistic abut the future als? If we leave matters to cure them-selves, the results may be disastrous. Prices may cntinue belw the cst fproduction for a suciently long time for entrepreneurs to feel that theyhave n recurse except an assault n the mney-incmes f the factrsf prductin (1930, Vl. 2, p. 385). (Emphasis added.)

Garrisn, in cmmn with Mises, Hayek and Machlup, begins

his analysis at a full emplyment stage in the cycle.4 Keynes, incntrast, starts at a stage characterised by extreme unemplyment.From start to nish his General Theory (1936) addresses theprblem f unemplyment. our reading f Keynes suggests that,in his mind, the full employment alternative was both dicult toverify and too obviously susceptible to ination if demand stimu-lating plicies were applied at the wrng stage in the cycle.5

Hwever, in the thirties Hayek was lking fr a real general

thery. It is fr this reasn that in his The Pure Theory of Capital(1941, pp. 373374) he criticized Keynes preccupatins with anunemplyment situatin and the ecnmics f abundance:

Nw such a situatin, in which abundant unused reserves f all kinds fresurces, including all intermediate prducts, exist, may ccasinallyprevail in the depths f a depressin. But it is certainly nt a nrmalpsitin n which a thery claiming general applicability culd be based.Yet it is sme such wrld as this which is treated in Mr. Keynes GeneralTheory of Employment, Interest and Money, which in recent years has created

4 Fr example, Fritz Machlup (1931, pp. 194195): In its riginal frmulatin, theMises-Hayek thery started frm a state f full emplyment and n this basis,it was possible to argue that investment ination will draw productive factorsaway frm the stages f prductin nearest t the cnsumer gds end, that thissituatin is nt tenable in the lng run, and that it is bund t lead t a reactin.It was easy t challenge this thesis f prductin structure distrtin by arguingthat it is invalid whenever there is a supply f unemplyed factrs. This argumentnally led Keynes to propose that complete disappearance of involuntary unem-plyment shuld be regarded as the prper limit f credit expansin. Until thepint at which this full emplyment has been reached, Keynes sees n particulardanger in nancing increased investment by means of credit creation.

5 In Chapters 10 and 12 f his Treatise, Keynes (1930) explains that the relatinshipbetween mney supply and the price level in the ld quantity thery is nly trueat the theretical equilibrium.


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s much stir and cnfusin amng ecnmists and even the widerpublic. Althugh the techncrats, and ther believers in the unbundedprductive capacity f ur ecnmic system, d nt yet appear t haverealised it, what he has given us is really that ecnmics f abundancefr which they have been clamuring s lng. or rather, he has given usa system f ecnmics which is based n the assumptin that n scarcityexists, and that the nly scarcity with which we need cncern urselvesis the articial scarcity created by the determination of people not to selltheir services and products below certain arbitrarily xed prices. Theseprices are in n way explained, but are simply assumed t remain at theirhistrically given level, except at rare intervals when full emplymentis approached and the dierent goods begin successively to becomescarce and t rise in price.

Garrisons work was heavily inuenced by the concept ofequilibrium. The same is true f Hayeks wrk in the early 1930swhen he was frmulating his business cycle thery that includedhis famus triangles and actively sparring with Keynes. As BruceCaldwell (1995, p. 14) explains:

Fr Hayek, any adequate thery f the business cycle must be cnsistentwith what he called equilibrium thery. This thery states that in afree-market system, changes in underlying cnditins f demand andsupply bring abut adjustments in relative prices, adjustments thatcntinue until demand and supply in all markets are equalized. S lngas relative prices are free t adjust, the price mechanism crdinates theactins f agents n bth sides f any market.

And then he adds:

one such market is the market fr lanable funds, where the interestsf savers and brrwers meet. In analyzing this market, Hayek usedWicksells cncept f a natural rate f interest, a rate that just equalizessavings and investment.

As nted by Ebeling, Salern, and even Garrisn himself inthe articles referenced abve, the capital-based macrecnmicsframewrk is based n the cntributin Hayek develped in

the thirties. Garrisns Hayekian Triangles d nt just representcapital structure in its narrwer sense, but includes the market frlanable funds in the brader sense in which bth Wicksell andHayek understd it.


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Herein lies the prblem: Hayek never rewrked his businesscycle thery after recgnizing the weakness f the equilibriumcncept in 1945.6 Nnetheless in his debate with Keynes andSraa, one nds references to problems anticipated in the demandstimulatin plicies advcated t revive the ecnmy. Caldwellunderlines this pint:

once the crisis had started, Hayek felt that the best plicy was simplyt allw it t play itself ut. Attempts t stimulate the ecnmy

thrugh further injectins f mney wuld nly keep the market ratearticially lowered that much longer, further distorting the structure ofprductin, prlnging and deepening the crisis. Attempts t stimulateconsumer demand would likewise be adding fuel to the re, sinceexcessive cnsumptin demand was a characteristic f this stage f thecycle. Indeed, the slump stage f the cycle was the painful medicineby which equilibrium in the system was ultimately restred (Caldwell,1995, p. 17).

And he cntinues (1995, p. 17) quting Lachmanns explanatinf Hayeks psitin:

Fr Hayek Paretian general equilibrium was the pivt f ecnmicthery, the centre f gravity twards which all majr frces tended. Frhim the task f trade cycle thery was t shw hw it came abut thatthese major forces were temporarily impeded and their eects delayed,and since the cycle was suppsed t start with a bm and end with adepressin, he saw in the depressin the ultimate triumph f the equili-brating frces (Lachmann, 1986, p. 227).

In the mdel, Garrisn essentially fllws Hayeks lead,explaining t Keynes and his fllwers by means f graphs hwthe ecnmy went frm full emplyment t high unemplyment.He is, in eect, pointing out that one cannot expect to remedy a

6 Ulrich Witt (1997) explains that in his earlier wrk Hayek fcused his researchn capital thery and business cycles. Later, he changed his research prgram tscial philsphy and the thery f spntaneus rder. These tw phases, Witt

argues, crrespnd t tw basically incmpatible research prgrams: generalequilibrium thery versus the thery f adaptatin, cllective learning and thefrmatin f expectatins. Hayek never recnsidered his business cycle thery inthe light f his later thinking. Witts article discusses the rle business cycle therymight play in a thery f spntaneus rder.


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lamentable situation without rst understanding how that state ofaairs arose in the rst place.

Hwever, in Prsperity and Depressin, Gttfried vnHaberler (1937, p. 284) explains:

It has ften been arguede.g., by Prfessr Hayekthat an analysisf the cycle must start frm an equilibrium with full emplyment. onecannt assume unemplyment frm the beginning, it is said, becauseit is the thing which has t be explained. But surely it must be pssible

and legitimate t investigate what happens when business has begunt expand after a depressin which has created much unemplymentand over-capacity, without rst explaining how the depression has beenbrught abut.

Hwever, what we are attempting t shw here, using the sameframework, is the answer to quite a dierent question, namely whythe Keynesian plicies currently s much in vgue as a respnset the sub-prime crisis f 2008 will fail yet again t return the

ecnmy t a sustainable full emplyment equilibrium situatin(oDriscll, 2009; Ravier, 2010b). Fr this reasn, and in cntrast tthe riginal mdel, ur starting pint shwn in Figure 4 is belowthe PPF, and symblizes a situatin f resurce underemplyment(bth human and capital). T put it mre clearly, here we areassuming an equilibrium with unemplyment situatin (t useKeynesian terminlgy) as ur pint f departure. This allws ust revisit the debate frm the pint where savings and investmentsare balanced despite sme unemplyment.

It shuld be clear that this situatin is the legacy f the previusecnmic cycle, analysed in Garrisns riginal framewrk. Thiswas the case in the Great Depressin f the 1930s which LinelRbbins (1934), Benjamin Andersn (1949), Murray Rthbard(1963) and ther ecnmists blamed n the pre-existing ecnmiccrisis. It shuld als be clear that this unemplyment situatinwuld nly persist if central banks cntinue manipulating themney supply r if the gvernment interferes with wage rates. As

Mises stated: [t]here prevails n a free labr market a tendencytward full emplyment. In fact, the plicy f letting the freemarket determine the height f wage rates is the nly reasnableand successful full emplyment plicy (1952, p. 153).


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Figure 4. Keyesia Equilibrium with Uemplymet

Consump-tion

C0

T0 I0

i0

I0;S0

S0

D0

Investment

InterestRate

Saving = Investment



HayekianTriangles

ProductionPossibilitiesFrontier (PPF)

Austrian business cycle thery addresses the cnsequences fcredit expansin by a mnetary authrity that reduces marketinterest rates belw their natural level. In Figure 5, we shw thisby the shift t the right f the lan supply curve and the lss fequivalence between savings and investments, which is cnsistentwith Garrisns mdel. Hwever in cntrast t Garrisns mdelwe shw the result f mnetary expansin nt as an ecnmic

bm beynd the PPF, but rather full emplyment at the PPF.7

It is imprtant t nte that what we have said abut the shrt-term eect is consistent with both the Hayekian and Keynesianappraches. In this sense, as Krugman (2010) suggests: In practice,Austrians seem t be Keynesians during bms.

7 James Ahiakpr (2008) questined the validity f Garrisns capital-based macr-ecnmic analysis n the grunds that it extends int the area beynd the PPFwhich is, by denition, outside the absolute maximum limit of output. Garrison(2008) oers his own response. This is not the place to elaborate on this, except toemphasize that our modication avoids that particular issue.


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Figure 5. Full Emplymet i the Shrt-Ru

Consump-tion

C0

C1

T0 I0

i0i1

I0;S0 I1S1

S0 S0+M

D0

Investment

InterestRate

Saving Investment



HayekianTriangles


A completely dierent situation arises if the economic system isat full emplyment r clse t it when mnetary expansin ccurs.The Hayekian Triangles then shw that it is pssible t increaseprductin f capital gds but only if consumer goods production issacriced in the short-run to release the factors of production required .Hwever, time will elapse befre additinal investment causes

an increase in the availability f cnsumer gds. In the case fthe Great Depressin, Keynes addressed the pssibility that theecnmy wuld remain in an unemplyment situatin frm whichnly active demand stimulatin plicies wuld enable it escape.

T this end, it shuld be remembered that Keynes essay TheGreat Slump of 1930 (1932) recmmends reducing the cst f mneybelw its natural level t attain full emplyment. In his pinin,use f the banking system prperly at all times8 t adjust theinterest rate apprpriately encurages r discurages investment.

8 This f curse suggests mniscience, the majr pint f divergence betweenHayek and ne-classical ecnmists nce Hayek revised his thery with respect tequilibriums rle after 1945.


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In the specic case of the Great Depression, Keynes asked the Bankf England and the Federal Reserve in the United States t pressurebanks t act in cncert and reduce interest rates, fr example tone half of one per cent, in order to stimulate benecial economicactivity and employment. He felt it would suce to convince thegeneral public f the plitical will t sustain the shrt-term interestrate at a lw level ver a lng perid f time fr this strategy tsucceed. Recent attempts t replicate this strategy demnstratent nly that the balance between cnsumptin and investment

alters, but als the structure f investments. Spiraling demand frination-proof assets such as gold and property suggest that thepublic are nt easily deceived, just as Hayek anticipated.

Hayeks criticism f Keynes Treatise essentially pints utthat without a capital theory, he cannot understand the eects of themonetary policy he proposes on relative prices, interest rates and capitalstructure. Hence in his review f the Method Problem , Hayektk Keynes t task bth fr relying n a macrecnmic mdel

lacking micrecnmic fundatins and fr ignring the crucialrleemphasized by Bhm-Bawerk and Wicksellcapital theryplayed in determining the interest rate.9

In Hayeks wn wrds (1931b, p. 277):

Such an explanation can, however, only be reached by a close analysis of thefactors determining the relative prices of capital goods in the dierent successivestages of productionfor the dierence between these prices is the onlysource of interest. But this is excluded from the outset if only total prots

are made the aim f the investigatin. Mr. Keynes aggregates cnceal themst fundamental mechanisms f change. (Emphasis in the riginal.)

Hayeks emphasis n capital-based macrecnmics in hiscriticism f Keynes highlighted Keynes fcus n the aggregateoutput eectrepresented by the PPFresulting from themarket fr lanable funds part f the mdel, which was precisely

9 Even Sraa (Hayek, 1995), in his criticism ofPrices and Production , accepted the

emphasis n relative prices: Taken as a whle, there is this t be said in favurof the bookthat it is highly provocative. Its one denite contribution is theemphasis it puts on the study of the eects of monetary changes on the relativeprices f cmmdities, rather than n mvement f the general price level nwhich attentin has almst exclusively been fcused by the ld quantity thery.


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the cmpnent derived frm an incmplete understanding fWicksell. We can therefre shw here that Keynes mitted acrucial dimension of the model, specically the inter-temporalstructure of production simplied in the Hayekian Triangles. It isprecisely this tl which animates the whle system and allws usto understand the micro-foundations aecting the movement ofallrelevant variables. The short-term duration of any positive eectsf mnetary plicy is highlighted as a cnsequence (see Hrwitz,2000, especially ch. 2).

In his review f Keynes Treatise, Hayek explains that:

If the increase f investment is nt the cnsequence f a vluntarydecisin t reduce the pssible level f cnsumptin fr this purpse,there is n reasn why it shuld be permanent and the very increasein the demand fr cnsumers gds which Mr. Keynes has describedwill put an end t it as sn as the banking system ceases t prvideadditinal cheap means fr investment. Here, his exclusive insistence nnew investment and his neglect f the prcess f reinvestment makeshim verlk the all-imprtant fact that an increase in the demand fr

cnsumers gds will nt nly tend t stp new investment, but maymake a cmplete rerganizatin f the existing structure f prductininevitablewhich wuld invlve cnsiderable disturbances and wuldrender it impssible, temprarily, t emply all labr (1932, p. 43).

Keynes might well have retrted that Hayeks laissez-faire impliesdeation, the very factor that contributed to the emergence ofHitler and Natinal Scialism in Germany. But Hayek (1932, p. 44),wuld then cunter that:

This deation is, however, a secondary phenomenon in the sense that it iscaused by the instability in the real situatin; the tendency will persist slng as the real causes are nt remved. Any attempt t cmbat the crisisby credit expansin will, therefre, nt nly be merely the treatment fsymptms as causes, but may als prlng the depressin by delayingthe inevitable real adjustments. It is not dicult to understand, in thelight f these cnsideratins, why the easy-mney plicy which wasadopted immediately after the crash of 1929 was of no eect.

In cnfrmity with Hayek, we shw in ur mdel that even iffull emplyment is reached thrugh active demand stimulatinplicies, this will be unsustainable due t the inability f a mnetaryauthrity t maintain lw interest rates in the lnger term. It


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shuld be nted t that this is nt a prcess f ver-investment,but mal-investment, which we believe is mre cnsistent with theAustrian literature in general and Mises in particular, as Salern(2011) recently emphasized.10

Figure 6. Uemplymet ad Destructi f Capital i theLong-Run

Consump-tion

C0

C1

T0 T2T1 I0I2 I1

i0i2

i1

I0;S0I2;S2 I1

S0S2 S0+M

D0

Investment

InterestRate

Saving = Investment



HayekianTriangles


C2

Figure 6 shws the unsustainability f the bm phase. Aspointed out earlier, the monetary authorities fear of ination leadsthem t abandn credit expansin. The lwest level f savingsthen determines the equilibrium interest rate: rates rise andinvestment suers as a consequence. Under such circumstancesthe interest rate rises well abve its initial level prir t the credit

10 Salern (2011, p. 14) has recently shwn that ABCT is nt an verinvestmentthery at all. In fact, Mises, Rthbard and, smewhat less emphatically, Hayekargued explicitly that vercnsumptin and malinvestment were theessential features of the inationary boom.


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prductive prcess is cmpleted nly in the lnger term des ntcnceal the n ging distrtin f bth relative prices and thecapital structure initiated when a mnetary authrity expands themney supply.

PART III: THE IMPLICATIONS OF THEPROPOSED MODIFICATION

We cnsider the apprach utlined here an extensin t the

riginal mdel with tw imprtant implicatins. First it makes iteasier t cntrast the Keynesian and Austrian strategies fr dealingwith an ecnmic dwnturn; secnd, it leverages the cncept fthe non-neutrality eect of monetary policy as a route towardsa mre cmplete understanding f why capital (and ptentiallyother resources as well) are irrevocably consumed in articiallystimulated bms.

The rst derives from our treatment of the PPF. The secondreects some qualitative aspects of resource utilization under the

stimulus of monetary expansion. Each of these claims is brieyelabrated in turn.

1) Adptig a pit belw the PPF as a cmmstartig pit makes ctrastig the Keyesiaad Austria strategies fr dealig with ecmicdwturs mre straightfrward:

We consider the eects of monetary policy from the samestarting pint as Keynes in bth his Treatise (1930) and GeneralTheory (1936), namely unemplyment f resurces. We demn-strate that expansionary monetary policy is eective at achievinga new equilibrium with full emplyment in the shrt run, butalso that in the longer-term the positive eects inevitably reversethemselves and the ecnmy cntracts int a new crisis anddeeper depressin.

It is imprtant t emphasise that we use the term equilibrium

nt merely t express the Austrian message t a Keynesian

the short run is precisely the rst stage of a chain of successive transformationswhich tend to bring about the long-run eects (1966, p. 296).


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audience, but rather in rder t demnstrate that the resultingfull employment situation is both inecient and temporary, justas Hayek intimated. As Garrisn (1996, p. 169) pinted ut: It isclear in his discussin fllwing the call fr scialized investmentthat Keynes is cncerned with the vlume and nt the directinf emplyment. In cntrast, the Austrian perspective in generaland Hayeks in particular is that nt every pint n the PPF impliesoptimum eciency, but only one pointthe one that reects theindividual preferences f ecnmic agents.

2. The failure f metary expasi as a lg-term

cure fr ecmic dwturs is a fucti f the

-eutrality f metary plicy, particularly

the irreversible use f resurces that results frm

metary stimulus.

one f the mst imprtant aspects f ABCT as it applies tmnetary plicy is the nn-neutrality f mney in bth the shrtand the lng run (Ravier, 2011). Basically, any mnetary plicyaects relative prices. If relative prices change because of monetarypolicy they inevitably aect such variables as economic activity andemplyment (Ravier, 2010a). T illustrate this pint, it is necessaryt distinguish between tw cmplementary prcesses which ccurat the stage f crisis and depressin.

Figure 7. Credit Expasi Eds with Uemplymet

Consumption

C0

C1

Investment

Production

Possibilities

Frontier (PPF)

C2

I0I2 I1


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On the one hand, as illustrated eectively by Garrisonsframewrk, at sme pint crisis and depressin in the ecnmyreaches a pint at which widespread frictinal unemplymentresults from bankruptcies. Resources, including signicant quan-tities f labr are idle and available fr re-deplyment. Figure 7illustrates the resultant under-utilizatin f resurces, but is silenton the potential capacity of the economy. In our modication, thesame cnsequence results when stimulatin f emplyment byarticially low interest rates ceases.

on the ther hand, and this is the mst relevant aspect, due tthe mal-investment prcess during the stimulus phase we alsface a situatin in which the ptential prductive capacity f theecnmy and thus the real wages ptentially earned nce theecnmy returns t nrmal levels f emplyment is reduced asa cnsequence f the partial destruction of capital. Many authrs,including fr example Huerta de St (1998, pp. 413-415), fcusattentin n the partial destructin f capital that inevitably

ccurs because there is a categry f resurces which are lstwhen investment projects are abandoned. Stimulus signicantlyincreases the vlume f resurces that ultimately fall in the sunkcst categry: at the end f the stimulus phase, sme resurceshave already been cmmitted t investment prjects but are ntyet prductive; when the stimulus phase ends and it turns ut thatthese prjects are nt ging t be cmpleted, these resurces aresunk csts and nt re-assignable t new prjects.

Figure 8. Credit Expasi Eds with Csumpti f Capital

Consumption

C0

C1

I0I2 I1 Investment

Production

Possibilities

Frontier (PPF)

C2


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What we therefre need t illustrate as a sequel t Figure 7 is thecmmn miscnceptin f thse wrking in the Chicag traditin,namely that it is pssible t use apparently idle resurces t returnt the situatin existing prir t the cycle. Thus in Figure 8 the PPFis lwer than we had in the initial situatin. This graph is silentn the idleness f resurces (bth human and capital) but shwsthe reductin f ptential prductin capacity that results frmmal-investment during the previus stimulus phase. We believethis dimensin f the prblem, which was ignred in Garrisns

graphs, deserves explicit recgnitin in future wrk.Furthermre, it is wrth nting that it fllws frm the premises

laid ut abve that ur extensin f capital-based macrecnmicsframewrk will nt be cnsistent with a Phillips curve with avertical slpe (Friedman and Phelps), but des cnfrm t thelgic behind a Phillips curve with a psitive slpe (Hayek, 1979;Ravier, 2010a; Mulligan, 2011).13

PART IV: ConCLUSIonSWe cnsider Garrisns wrk ne f the mst imprtant cntri-

butins by the Austrian Schl in the past decade. In additin tthe mdels pedaggical value and its rle in re-kindling interest inthe cntributins Hayek made in the 1930s (ver-shadwed at thetime by Keynes), capital-based macrecnmics appears t havepotential applications in the eld of comparative economics. Inthis paper we have attempted t take sme tentative steps dwnthat rad.

The fllwing Table summarizes the arguments laid ut,cmparing the riginal mdel with the extensin suggested here.

13 Fr similarities and diferences between the Austrian and the Chicag apprach,see als Ravier and Schenne (2007).


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Original Model Revised Model

Starting Point

Objective

The Short-Run Effectof Monetary Policy

The Long-Run Effectof Monetary Policy

Austrian Schoolversus Keynesianism

Full employmentsituation. Representedby a point on the PPF.

To explain the cause ofthe crisis anddepression, along withthe consequentunemployment.

Over-consumption andover-investment. Themonetary policy movesthe economytemporarily to a pointthat is above the PPF.

Unemployment situation.Represented by a pointbelow the PPF.

To explain the reasonwhy expansionarymonetary policy will failto stimulate the economyin the long term and thus

is incapable of facilitatingrecovery from a recession.

Full employment.Monetary policy has atransitory impact onconsumption andinvestment, moving theeconomy to a point onthe PPF. We have mal-investment, but notover-investment

(Salerno, 2011).

The effect of monetarypolicy is reversed. Anew equilibrium withunemployment attained.

The effect of monetarypolicy is reversed. A newequilibrium withunemployment isreached, but potentialproductive capacity isconsumed in the process.

Solves a problem thatKeynes does not raise.

Facilitates comparisonwith the Keynesian

remedy. Shows that thebenefits of the Keynesianprescription are onlyshort-term effects.

Phillips Curve Consistent withFriedman and PhelpsPhillips Curve.

Consistent with a PhillipsCurve having a positiveslope (Hayek, 1979;Ravier, 2010a;Mulligan, 2011).


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Rethinking Capital Based Macroeconomics - Adrian Ravier