Dowd offers a classical-liberal perspective on macroeconomic policy and specifically central-bank policy. Having written extensively on free banking, he concludes that a thorough decentralization of the banking business is essential to enduring macroeconomic stability. Hutchinson is a seasoned investment banker turned financial journalist. His firsthand, nuts-and-bolts knowledge of modern financial markets undergirds his broader perspective. Together, they provide an enlightening account of the long-run trends and short-sighted policy actions that culminated in the worst financial crisis since the Great Depression.

The “alchemists” in their story are the architects and practitioners of modern finance. Given the perverse regulatory environment, buying and selling derivatives can yield short-run profits to hedge funds and other traders while virtually guaranteeing that in the longer run the owners of the underlying real assets will suffer losses if not bankruptcy. The careful reader will understand that speculation, whether on a long-term or short-term basis, is an essential and healthy feature of a market economy. But, if anything, the authors’ likening of speculation to alchemy when it is based on the techniques of modern finance and carried out in the context of a regulated economy understates the perversity. On reflection we can see that turning future long-run losses (of other people) into current short-run profits (for yourself) is triply more disruptive than trying to turn lead into gold. We can note 1) that lead, unlike long-run losses, has a positive, though modest, value; 2) that it is your own lead; and 3) that given the laws of nature, you’re unable to turn the trick.

But if the laws of nature keep people from turning lead into gold, why don’t the laws of the marketplace preclude the financial alchemy that characterized most of this century’s first decade? The answer, our authors make clear, is government intervention. A toxic mix of interventions (regulatory, fiscal, and monetary) perverted the coordinating market forces by removing considerations of long-run systemic risk. The result was a systemic discoordination whose increasing severity eventually turned systemic risk into a crisis. The laws of the marketplace, if allowed to exert themselves, can preclude financial alchemy (or at least put strict limits on it). But government intervention, including loan guarantees and the too-big-to-fail doctrine, open a window in which short-run profit-taking in financial markets is pitted against long-run viability of the financial institutions.

While the Federal Reserve is recognized as an essential accommodating element in the most recent episode of boom and bust, Dowd and Hutchinson focus on the inherent perversity of modern finance theory in the context of the long-running efforts of the government to redistribute income and to encourage homeownership. Since the 1930s the government has used the tax code to redistribute incomes downward. Over the years the income tax—and over the generations the inheritance tax—has reduced the number of families that oversee their long-run business interests. The old partnerships (Dowd and Hutchinson’s term), which kept the owners’ skins in the game, have been supplanted by limited-liability corporations, which effectively separate management and ownership. This critical separation, which left-leaning authors take to be characteristic of capitalism, is shown by the authors to be a consequence of government systematically overriding the market-governed distribution of income. Whereas we once had business families that were in it for the long run, we now have financial managers and traders in derivatives markets who are in it for the short run, ultimately to the detriment of the financial system and the real economy.

Alchemists of Loss provides a multidimensional account of the nature and magnitude of our long-brewing economic woes. But the book provides us with little hope for the future. The authors’ suggestions for reform range from the radical (reinstating the gold standard and eliminating the central bank) to the not-so-radical (redrafting the Fed’s mandate to exclude concern about unemployment) to the superficial (moving the Fed’s headquarters to St. Louis). Even the casual reader will see that this extends from the virtually impossible to the not-worth-doing, with no promising midrange option. The implicit conclusion is that we should brace ourselves for more booms and busts.

Roosevelt dominates the dust jacket of the book but is the background throughout most of its nine chapters. Cohen puts the spotlight on the key operatives during the first hundred days–Raymond Moley, Lewis Douglas, Henry Wallace, Frances Perkins, and Harry Hopkins. These are the people who had Roosevelt’s ear. As Cohen suggests, what Roosevelt knew was whatever he’d heard most recently. The hard left turn that America took during those days didn’t come from any top-down planning of the administration but rather from the decisive triumph of the socialist-minded secretary of labor (Frances Perkins) and others over the ultraconservative budget director (Lewis Douglas). Douglas’s defense of fiscal responsibility was no match at all for the pre-Keynes Keynesianism touted by Perkins. And in matters of economic theory, Roosevelt himself was completely out of play. Perkins was accustomed to addressing issues on a theoretical level, or so Cohen reports, while FDR, in Perkins’s assessment, was “illiterate in the field of economics.”

But where did Perkins get her own economic literacy? Not from Keynes, although his ideas were in the air. Perkins’s belief that spending is the key to prosperity came from her studies at the University of Pennsylvania under Simon Nelson Patten, whom Cohen calls a “renowned economist.” Though Cohen doesn’t dig further into the Patten-Perkins connection, we can note that Patten (1852-1922) had studied abroad, becoming immersed in the ideas of the German Historical School. Hence, the views he imparted to Perkins could hardly be described as “theoretical.” In espousing policy Patten was guided by a Keynesianesque vision in which a spiral-prone economy can be controlled by government spending. Cohen quotes Perkins: “The depression is feeding on itself. . . .” And “[w]e must have mass consumption or we will never get a market for mass production.” From day one Perkins was the driving force for a large-scale public-works program meant to provide the income to get the mass consumption and production going.

As a coincidence of timing, Cohen’s book provides eerie insights into the first hundred days of the Obama administration. The parallels are impossible to miss. For instance, then as now, the political rhetoric entailed a commitment to budget cutting, while at the same time promising massive spending to stimulate the economy. This schizo fiscal posturing reminds us of the episode involving the Bush-initiated project to produce a fleet of 28 “Marine One” presidential helicopters. By the time Bush left office cost overruns had increased the projected cost per copter to $500 million. The Obama administration scrapped that wasteful project while simultaneously appropriating funds for a Harry Reid-supported high-speed rail service between Las Vegas and Los Angeles. (We wonder why the helicopter project wasn’t kept on track–with plans to press the copters into service shuttling Reid’s constituents between Vegas and L. A.) Senator Reid later gave up on this expensive folly, but the parallels between FDR’s and Obama’s cost-cutting-cum-reckless-spending propensities remain.

For another instance, the procedures for sizing the “stimulus” packages then and now should be enough to kill confidence in government spending policies. How did the Obama administration decide that its “stimulus” package needed to be $787 billion? Even the Obama-friendly media recognized that numbers were just cobbled together–and without anyone actually reading the final bill.

In 1933 a key determinant of the actual amount stipulated in the Industrial Relief Bill involved a failure to hear rather than a refusal to read–at least, according to Harold Ickes’s account as reported by Cohen. Just before submitting his bill, Senator Robert Wagner (D-NY) shouted to his secretary in an adjacent office, “Does the $3.0 billion for public works include the $300 million for New York?” The secretary shouted back, “I put it in,” but Wagner heard only “Put it in.” So, he made the adjustment and submitted a $3.3 billion spending bill.

Cohen ends his book on a warm and positive note. He offers a summary of Roosevelt’s accomplishments, focusing on the National Industrial Recovery Act, the capstone legislation of the first hundred days: “Although much of [the NIRA] failed, it still changed America. The workers’ rights and public works provisions not only improved the lives of millions of destitute Americans they marked the triumph of one faction of the administration, led by Perkins, Wallace, and Hopkins, and the defeat for another, led by Douglas. Taken together, these provisions stood for something fundamental: recognition of the federal government’s responsibility to look after its citizens.”

Alas, still another parallel–the rosy perceptions and favorable ratings of Roosevelt and Obama, despite the arbitrariness, incoherence, and perversities of their policies.

DeLong blithely rejects the Austrian account. In his lecture delivered January 5 in Singapore, “The Financial Crisis of 2008–2009: Understanding the Causes, Consequences—and Possible Cures,” he fabricates a “Marx-Hoover-Hayek axis” (complete with adjoined photos of this unlikely trio) and then offers a brief and ill-informed critique under the heading “The ‘Austrian’ Story in a Nutshell.”

A true-to-Hayek nutshell version of the Austrian theory is not difficult to produce. The central bank is central to our understanding of the current crisis. The Federal Reserve under the leadership of Alan Greenspan kept interest rates too low during 2003 and 2004 and then ratcheted the rates steeply upward. Time-consuming investments that were initiated while cheap credit made them artificially attractive were then made prohibitively costly to carry through. Macroeconomically, that sequence translates into an Austrian-style boom and bust. The background against which the story unfolded was a long-running, politically motivated sequence of housing policies whose dubious goal was to increase home ownership beyond what mortgage markets themselves would allow. The actual effect of the various policies was to desensitize both lenders and borrowers to the risk of default, causing mortgage markets and hence housing markets to play leading roles in this particular boom-bust episode.

The Austrian theory couldn’t be more tailor-made for understanding our current situation. Dealing with the unfortunate consequences of artificially cheap credit, a memorable passage in Mises’s Human Action (3rd ed., 1966, p. 560) alludes to an overbuilt housing market:

The whole entrepreneurial class is, as it were, in the position of a master builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan . . . [that cannot be fully executed because] the means at his disposal are not sufficient. He oversizes the groundwork and the foundation and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure.

The foiled plans in Mises’s parable represent the upper turning point of the business cycle. The subsequent compounding of the downturn in the form of a downward spiral into deep recession should not distract attention from the underlying problem of the credit-induced misallocation of resources. The solution must entail, in the first instance, a reallocation of those misallocated resources.

If credit creation by the central bank was the cause of the problem, it is doubtful that still more credit creation is the solution. Similarly, if investment activity was overstimulated by cheap credit, it is doubtful that a stimulus package will hasten recovery. Why, then, isn’t there a general recognition of the implausibility of these textbook solutions? And why don’t mainstream macroeconomists see the direct applicability of the Austrian theory and the appropriateness of a market solution to the crisis?

Votes Now, Bust Later

For the economist-turned-policymaker, the answer is simple. Policies based on mainstream thinking—cheap credit and stimulus packages—are politically attractive, a circumstance that makes any other theory, particularly as it might apply to the long run, wholly irrelevant. Attempts to rekindle the boom also satisfy the “don’t-just-stand-there” criteria for political viability. In the long run a boom will get you a bust; but in the short run, a boom will get you votes. No doubt, many elected officials are oblivious to the first part of this long-run/short-run distinction. And virtually all those not so oblivious see the second part as trumps.

For academic macroeconomists, especially for those trained and employed by top-tier universities, we need a two-part answer to our question. For Part I we must recognize that economists who were trained at Harvard or MIT and hold a faculty position at Berkeley or Princeton have trouble grasping the Austrian theory. They learned their (short-run) macroeconomics and their (long-run) growth theory in two different sets of courses. The capital theory that unites these two subject areas in the Austrian literature was effectively out of play in both sets. In mainstream macro, where business cycles were discussed, capital is assumed to be fixed. In mainstream growth theory, where cyclical movements are assumed away, capital is allowed to grow or to shrink, but it enters the theory as a holistically conceived capital stock.

By contrast, the inherent time dimension in the economy’s capital structure makes capital theory a natural common denominator for Austrian macro-economics and Austrian growth theory. Capital is a sequence of stages of production; its temporal structure is a key macroeconomic variable. Interest rates that reflect people’s preferred tradeoff between consuming now and consuming later guide capital creation and allow for sustainable growth. Almost as a corollary, interest rates that are distorted by central-bank policy misguide capital creation and give rise to unsustainable growth. The inevitable bust (in the recent and earlier episodes) is a dramatic manifestation of the growth rate’s unsustainability.

To mainstream macroeconomists, the mix of cycles, growth, and the temporal allocation of resources makes Austrian theory appear as a disorienting mishmash. The mainstreamers are not won over; they are simply flummoxed. At best, they will try to fit piecemeal the various propositions put forth by the Austrians into an otherwise mainstream theoretical framework. Distortions of the capital structure get translated into unwarranted changes in the size of the capital stock; the plausibility of entrepreneurs being misled by cheap credit gets judged in the light of presumed “rational expectations.” The unemployment of labor during the period of capital restructuring gets questioned on the basis of the efficient-market hypothesis. Individually, the pieces don’t fit, and so collectively the Austrian propositions are rejected wholesale. (Notice that the Austrian theory is better received by Wall Street analysts trained in finance and attuned to the real economy than by academic macroeconomists.)

Part II of the answer to “Why don’t the mainstreamers see the Austrian theory’s relevance?” actually deals with a follow-on question. “Why don’t they at least make the effort to learn what the Austrian theory is?” After all, economists who study and teach at top-tier universities are intelligent people who could learn the Austrian theory. A little reflection suggests that while they surely have the ability, they lack the motivation. For a seasoned member (or even an upstart member) of the Berkeley or Princeton faculty, studying Austrian economics is just not a career-enhancing activity.

Theories that they do know, which include New Keynesian, New Classical, and Real Business Cycle Theory, fail to incorporate capital theory in any meaningful way. And although advertised as “new” and “real,” none of these theories have more than a tenuous link to current economic reality. Further, these mainstream theories have now begun to merge together into technically demanding and other-worldly constructions called Dynamic Stochastic General Equilibrium (DSGE) models. For mainstream macroeconomists, the DSGE models are the wave of the future. They are the vehicles for publications and professional advancement. (Googling “Dynamic Stochastic General Equilibrium” yields more than 80,000 results.) Any attention to the Old Austrian theory, then, can only divert their careers in an unrewarding direction.

When the mainstreamers are called on to make a public statement about the current economy or to make a policy recommendation, they find their DSGE models wholly unserviceable. And so they simply fall back on the simplest, principles-level version of these complex formal models—which, not surprisingly, is the Old Keynesian theory. Their policy positions are based on the decades-old textbook construction in which earning and spending are locked into a spiral-prone circular flow—and in which countering a downward spiral requires a deficit-financed stimulus package.

Austrian Theory in a Mainstream Straitjacket

The short final section of DeLong’s Singapore lecture, his nutshell rendition of the “Austrian Story,” presents us with a particularly significant case study of the mainstream perspective on Austrian theory. During the several months before his January lecture, DeLong had multiple encounters with the Austrian theory as applied to our current financial crises. The Cato Institute’s 26th Annual Monetary Conference (held in November 2008) was titled “Lessons from the Subprime Crisis.” Among the dozen or so papers presented at that conference, the Austrian school was well represented. Although DeLong was not a conference participant, he reacted on December 8 to an online version of Lawrence H. White’s conference paper, “What Really Happened,” with a critique titled, “Liquidity, Default, Risk.” White responded on December 10 with an insightful defense of the Austrian theory. This exchange of ideas was then followed by still more contributions to “The Conversation” stemming from the White paper and including four additional comments by White. (The DeLong-White exchange is accessible through www.catounbound.org, and all the conference papers appear in the winter issue of the Cato Journal.)

So what effect did this virtual immersion in Austrian theory have on DeLong’s understanding? The answer: little or none. Although his January “nutshell” is just too small to contain much understanding at all, it does contain evidence of the continuing fundamental misunderstandings typical of mainstream critiques.

DeLong’s explanation of the Austrian view makes reference only to “the economy’s capital stock”—that phrase from mainstream macroeconomics that treats capital holistically. Willful or not, DeLong has distorted the Austrian theory by force-fitting it into his mainstream macroeconomic framework. And in DeLong’s rendition of the Austrian view, we see that the “overinvestment” that characterized the boom implies that “the economy’s capital stock needed to shrink.” A two-panel diagram showing “boom” and “crash” is used to depict the sequence of overinvestment and shrinkage. The demand for risky assets first rotates up producing the boom and then rotates back down precipitating the crash. The Austrians themselves would claim, instead, that the malinvestment (Mises’s term) that characterizes the boom implies the need for a capital restructuring. In other words, the allocation of resources within the capital structure has to be brought in line with post-boom market rates of interest. This restructuring takes some time and is best achieved, in the Austrians’ view, by the market itself.

From the Time Dimension to the Moral Dimension

Turning a blind eye to the notions of malinvestment and capital restructuring, DeLong quickly shifts ground from economics to ideology and from F. A. Hayek to Herbert Hoover. (We will take DeLong’s inclusion of Marx in his discussion as pure hyperbole.) DeLong takes the Austrians’ call for a market solution (capital restructuring) rather than a government solution (rekindling the boom) as justification for denigrating the Austrians as “liquidationists,” a label popularized by DeLong himself in earlier articles and associated in his own thinking with Hayek, Hoover, and Hoover’s treasury secretary, Andrew Mellon. The specific recommendations that Mellon supposedly offered for dealing with the 1929 crash and its aftermath are, by themselves, almost enough to call this association into question:

Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.

Significantly, DeLong’s broad-brush use of the term “liquidationism” was criticized by White in a 2008 paper titled, “Did Hayek and Robbins Deepen the Great Depression?” (Journal of Money Credit and Banking, June issue). In arguing the absence of a Hayek-Hoover connection, White is convincing on two key points. First, sheer chronology precludes the possibility of Hayek having a timely influence on Mellon and/or Hoover. Hayek’s first English-language statement of the Austrian theory was not published until 1931. Besides, a much more obvious basis for Mellon’s thinking was the fallacious Real Bills Doctrine, which was written into the legislation that created the Federal Reserve System. Second, there is no evidence that the above quoted passage can actually be attributed to Mellon. It comes from Hoover’s Memoirs (1952) and reads like a caricatured rendition of Mellon’s views—a rendition that sets the stage for Hoover’s rejection of those views.

For the Austrians the liquidation of malinvestments is essential to the economy’s recovery. Resources need to be reallocated. Hence, any government spending program that serves to rekindle the housing boom or even to keep resources from leaving the housing industry is counterproductive. It locks in the misallocated resources. Similarly, restoring macroeconomic health requires the liquidation of many other long-term or early-stage investments whose expected profitability depended on artificially low borrowing costs.

This needed liquidation does not imply that “a panic would be not altogether a bad thing,” a judgment that DeLong also attributes—via Hoover—to Mellon. What Mellon (or Hoover) called a panic, Hayek called a “secondary contraction,” meaning a self-reinforcing spiraling downward of economic activity that causes the recession to be deeper and/or longer-lasting than is implied by the needed liquidation of the malinvestment. Hayek argued, in effect, that the “ideal” policy would be one that allows the needed liquidation to proceed at market speed while the monetary authority curbs the secondary contraction (the panic) by maintaining a constant flow of spending. In terms of the equation of exchange (MV=PQ), Hayek argued that the ideal policy was to keep MV—and hence PQ—constant by increasing the money supply (M) just enough to offset declines in money’s velocity of circulation (V). Hayek used the word “ideal” in recognition that the monetary authority may lack both the technical ability and the political will actually to implement that policy. (It would lack the technical ability because it would have no way of getting timely information on the changes in money’s circulation velocity; it would lack the political will because pulling money out of the economy when eventually the velocity begins to rise is a politically unpopular thing to do.) But in any case, Hayek and the Austrians generally regarded the secondary deflation as “altogether a bad thing.” (In Hayek’s later writings, he favored a decentralized monetary system—in which market forces, rather than an ideally managed central bank, would govern changes in the money supply.)

Mellon is charged (by DeLong and many others) with having a “moral objection” to curbing even the secondary contraction. This moral dimension to Mellon’s supposed liquidationism tends to get imputed to the Austrian view as well. DeLong quotes Martin Wolf (Financial Times, Dec. 23, 2008) at some length on this point. Wolf insisted (with a bow to Keynes) that “we should approach an economic system not as a morality play but as a technical challenge.”

It is worth noting here that characterizing the Austrian Story as a morality play is not original with Wolf—and certainly not with DeLong. Most likely, this particular putdown comes from Paul Krugman, whose understanding of Austrian theory rivals DeLong’s. Krugman’s introduction to the 2006 printing of John Maynard Keynes’s General Theory of Employment, Interest, and Money contains the following passage:

Keynes’s limitation of the question [about a depressed economy] was powerfully liberating. Rather than getting bogged down in an attempt to explain the dynamics of the business cycle—a subject that remains contentious to this day—Keynes focused on a question that could be answered. And that was also the question that most needed an answer: Given that overall demand is depressed (never mind why), how can we create more employment? A side benefit of this simplification was that it freed Keynes and the rest of us from the seductive but surely false notion of the business cycle as morality play, of an economic slump as a necessary purgative after the excesses of a boom. By analyzing how the economy stays depressed, rather than trying to explain how it became depressed in the first place, Keynes helped bury the notion that there’s something redemptive about economic suffering.

The Austrian Story is not a morality play. It is a piece of economic analysis. Nor is it just some variation on a theme that can be understood in terms of the analytical framework of mainstream macroeconomics. Rather, Mises and Hayek offered a more encompassing macroeconomic framework, one that illuminates the market mechanisms that allocate resources among the temporally defined stages of production and traces the intertemporal misallocation of those resources to misguided or politically motivated policies of the central bank.

It is important to see that the whole focus of mainstream macroeconomics, and certainly DeLong’s focus, is fundamentally different from the focus of the Austrian economists. The difference, fully recognized by White in his response to DeLong, is captured in Krugman’s introduction to Keynes’s General Theory. Keynes suggested remedies for the ongoing depression without bothering himself about just how the economy came to be depressed in the first place. Throughout the Singapore lecture, DeLong, following Keynes, argues as if it is simply in the nature of capitalism that there are waves of speculation followed by a collective quest for liquidity—for more liquidity than can be readily accommodated in a modern capital-intensive economy. The central bank comes into play only to counter the economy’s wealth-destroying gyrations.

Hayek focused on the dynamics of the preceding boom, thinking that the question of how the economy came to be depressed was the most interesting and challenging question, and believing that a satisfactory answer to that question was a strict prerequisite to figuring out how (and how not) to deal with the depressed economy.

An Austrian Perspective on Suffering

There is nothing “redemptive about economic suffering.” Krugman, Wolfe, and DeLong are right about that. There is also nothing redemptive about the suffering of the Austrian school in the wake of ill-informed criticism. But the Austrian ideas will continue to suffer as long as mainstream macro continues to develop along its current path. And the suffering of the economy will continue—and intensify—as long as policymakers, following their political instincts and enjoying the support of mainstream economists, opt for ever-bigger stimulus packages to be financed by mushrooming debt.

The economics of John Maynard Keynes as taught to university sophomores for the last several decades is now nearly defunct in theory but not in practice. Keynes’s 1936 book, The General Theory of Employment, Interest, and Money, portrayed the market as fundamentally unstable and touted government as the stabilizer. The stability that allegedly lay beyond the market’s reach was to be supplied by the federal government’s macroeconomic policymakers—the president (with guidance from his Council of Economic Advisers), the Congress, and the Federal Reserve.

The acceptance in the economics profession of fundamentalist Keynesianism peaked in the 1960s. In recent decades, enthusiasm for Keynes has waxed and waned as proponents have tried to get new ideas from the General Theory or to read their own ideas into it. And although the federal government has long since become a net supplier of macroeconomic instability, the institutions and policy tools that were fashioned to conform to the Keynesian vision have become an integral part of our economic and political environment.

A national income accounting system, devised with an eye to Keynesian theory, allowed statisticians to chart the changes in the macroeconomy. Dealing in terms of an economy-wide total, or aggregate, policy advisers tracked the production of goods and services bought by consumers, investors, and the government. Fiscal and monetary authorities were to spring into action whenever the economy’s actual, or measured, total output, which was taken to reflect the demand side of markets, fell short of its potential output, which was estimated on the basis of the supply side. Cutting taxes would allow consumers and investors to spend more; government spending would add directly to the total; printing money or borrowing it would facilitate the opposing movements in the government’s revenues and its expenditures.

A chronic insufficiency of aggregate demand, which implies that prices and wages are somehow stuck above their market-clearing levels, was believed to be the normal state of affairs. Why might there be such pricing problems on an economy-wide scale? What legislation and government institutions might be standing in the way of needed market adjustments? These questions were eclipsed by the more politically pressing question of how to augment demand so as to clear markets at existing prices. The New Economics of Keynes shifted the focus of attention from the market to the government, from economically justified changes in market pricing to politically justified changes in government spending.

Politicians still appeal to basic Keynesian notions to justify their interventionist schemes. The continued use of demand-management policies aimed at stimulating economic activity—spending newly printed or borrowed money during recessions and before elections—requires that we understand what Keynesian economics is all about and how it is flawed. Also, identifying the flaws at the sophomore level helps students to evaluate in their upper-level and graduate courses such modern modifications as Post-, Neo-, and New Keynesianism as well as some strands of Monetarism.

The extreme level of aggregation in Keynesian economics leaves the full range of choices and actions of individual buyers and sellers hopelessly obscured. Keynesian economics simply does not deal with supply and demand in the conventional sense of those terms. Instead, the entire private sector is analyzed in terms of only two categories of goods: consumption goods and investment goods. The patterns of prices within these two mammoth categories are simply dropped out of the picture. To make matters worse, the one relative price that is retained in this formulation—the relative value of consumer goods to investment goods as expressed by the interest rate—is assumed either not to function at all or to function perversely.

Keynes’s Neglect of Scarcity

Pre-Keynesian economics, such as that of John Stuart Mill, as well as most contemporaneous theorizing, such as that by Ludwig von Mises and F. A. Hayek, emphasized the notion of scarcity, which implies a fundamental trade-off between producing consumption goods and producing investment goods. We can have more of one but only at the expense of the other. The construction of additional plant and equipment must be facilitated by increased savings—that is, by a decrease in current consumption. Such investment, of course, makes it possible for future consumption to increase. Identifying the market mechanisms that allocate resources over time is fundamental to our understanding of the market process in its capacity to tailor production decisions to consumption preferences. But as Hayek noted early on, the Keynesian aggregates serve to conceal these very mechanisms so essential to the intertemporal allocation of resources and hence to macroeconomic stability.

In Keynesian theory the long-established notion of a trade-off between consuming and investing is simply swept aside. Consistent with the assumed perversity of the price mechanism, the levels of consumption and investment activities are believed always to move in the same direction. More investment generates more income, which finances more consumption; more consumption stimulates more investment. This feature of Keynesian theory implies an inherent instability in market economies. Thus the theory cannot possibly explain how a healthy market economy functions—how the market process allows one kind of activity to be traded off against the other.

The “Multiplier-Accelerator” Theory

The inherent instability makes its textbook appearance as the interaction between the “multiplier,” through which investment affects consumption, and the “accelerator,” through which consumption affects investment. The multiplier effect is derived from the simple fact that one person’s spending becomes another person’s earnings, which, in turn, allows for further spending. Any increase in spending, then, whether originating from the private or public sector, gets multiplied through successive rounds of income earning and consumption spending.

The accelerator mechanism is a consequence of the durability of capital goods, such as plant and equipment. For instance, a stock of ten machines, each of which lasts ten years, can be maintained by purchasing one new machine each year. A slight but permanent increase in consumer demand for the output of the machines of, say, 10 percent, will justify maintaining a capital stock of eleven machines. The immediate result, then, will be an acceleration of current demand for new machines from one to two, an increase of 100 percent.

The multiplier-accelerator theory explains why consumption is increasing, given that investment is increasing, and why investment is increasing, given that consumption is increasing. But it is incapable of explaining what determines the actual levels of consumption and investment (except in terms of one another), why either should be increasing or decreasing, or how both can increase at the same time. Students are left with the general notion that the two magnitudes, investment and consumption, can feed on one another, in which case the economy is experiencing an economic expansion, or they can starve one another, in which case the economy is experiencing an economic contraction. That is, Keynesian theory explains how the multiplier-accelerator mechanism makes a good situation better or a bad situation worse, but it never explains why the situation should be good or bad in the first place.

Only at the two extremities in the level of economic activity is a change in direction of both consumption and investment sure to occur. After a long contraction, unemployment is pervasive and capital depreciation reaches critical levels. As production essential for capital replacement stimulates further economic activity, the macroeconomy begins to spiral upward. After a long expansion, the economy is bulging at the seams. Markets are glutted with both consumers’ and producers’ goods. As unsold inventories trigger production cutbacks and worker layoffs, the macroeconomy begins to spiral downward. Keynes held that the economy normally fluctuates well within these two extremes experiencing a general insufficiency—and an occasional supersufficiency—of aggregate demand.

Textbook Keynesianism

In the simplistic formulations of macroeconomic textbooks, investment is simply “given”; in Keynes’s own formulation, the inclination of the business community to invest is governed by psychological factors as summarized by the colorful term “animal spirits.” Keynes recognized that there are some “external factors” at work, such as foreign affairs, population growth, and technological discoveries. The market is envisioned, in effect, to be some sort of economic amplifier which converts relatively small changes in these external factors into wide swings of employment and output. This is the basic Keynesian vision.

Wage rates and prices are assumed either to be inflexible or to change in direct proportion to one another. In either case the real wage (W/P) is forever constant. The actual level of wages and prices is believed to be determined (again) by external factors—this time, trade unions and large corporations. If the real wage is too high, there will be unemployment on an economy-wide basis. There will be idle labor and idle resources of every kind. The opportunity cost of putting these resources back to work is nothing but forgone idleness, which is no cost at all. The assumed normalcy of massive resource idleness assures that the perennial problem of scarcity never comes into play. William H. Hutt and F. A. Hayek were justified in referring to Keynesian economics as the “theory of idle resources” and the “economics of abundance.”

Textbook Keynesianism has a certain internal consistency or mathematical integrity about it. Given the assumptions that prices and wages do not properly adjust to market conditions—that is, the assumption that the price system does not work—then the Keynesian relationships among the macroeconomic aggregates come into play. Even the policy prescriptions seem to follow: If wages and prices do not adjust to the existing market conditions, then market conditions must be adjusted (by the fiscal and monetary authorities) to the externally determined prices and wages.

In the final analysis, however, Keynesian theory is a set of mutually reinforcing but jointly unsupportable propositions about how certain macroeconomic aggregates are related to one another. Keynesian policy is a set of self-justifying policy prescriptions. For instance, if the government is convinced that wages will not fall and is prepared to hire the unemployed, then unemployed workers will not be willing to accept a lower market wage, ensuring that wages, in fact, will not fall. Thus, while the intention of Keynesian policy is to stabilize the economy, the actual effect is to “Keynesianize” the economy. It causes the economy to behave in exactly the same perverse manner that is implied by the Keynesian assumptions. This convoluted interrelationship between theory and policy has long obscured the fundamental flaws in the theory itself.

Students often ask the obvious question: Why is government policy grounded in such a flawed theory? From a political point of view, advocating and implementing Keynesian policy is the surest way to election and reelection. The gains from printing and spending money are immediate, highly visible, and can be concentrated on individuals who make up powerful voting blocs. The costs of this policy are incurred at a later date and can be spread thinly across the entire population, making the link between policy and long-run consequences difficult for the voting public to perceive.

The fading in recent years of old-line Keynesianism in academic circles provides little comfort. Even as the number of demand-managers continues to decline, it is from this shrinking group of economists that government officials seek advice and reconciliation. And opportunities to lecture to the seats of power rather than in the halls of learning have a way of changing some economists’ minds about the advisability (political if not economic) of managing aggregate demand. Printing and spending money in pursuit of short-run stimulation if not long-run stability remain the order of the day.

There is good reason, then, to study Keynesian theory: It helps us understand what the policymakers in government are likely to do in any given circumstance. But to understand the actual effects of their demand-management policies in the long run as well as the short, we need a more enlightening theory—one that recognizes what market forces can do on their own to maintain macroeconomic stability and how those forces are foiled by government-supplied stabilization.

On average, Federal Reserve chairmen come and go at about the same rate as U.S. presidents. Dating from the creation of this country’s central bank (1913), we have seen 16 presidents (Wilson to Bush) and 14 Fed chairmen (Hamlin to Bernanke). The Fed chairmanship, however, has seen more variation in years of service—Franklin D. Roosevelt notwithstanding. Spanning four presidencies, Alan Greenspan’s reign (1987–2006) was the second longest. Greenspan was outdistanced (but only by a few months) by William McChesney Martin (1951–1970), who served five presidents.

The first half-dozen Fed chairmen belong to a different era—during which the primary locus of control on policy matters was the New York Federal Reserve Bank. It was that bank’s Benjamin Strong and, following him, George Harrison who were key operatives during the late 1920s’ expansion and the subsequent crash and descent into deep depression. And it was just as the economy was bottoming out that Congress passed legislation (in 1933 and 1935) that, among other things, shifted power to Washington. Though there is no Federal Reserve Bank in the nation’s capital, the Eccles Building on Constitution Avenue, built in 1937 and now named for the seventh Fed chairman, houses the Board of Governors and, most importantly, the chairman of the Board.

Like Marriner Eccles, the early and middle Fed chairmen were not economists. Instead, they had backgrounds in law, banking, or finance. But starting with Arthur Burns (1970–1978) and allowing for one short gap of 17 months, an economist has been at the top of this country’s banking pyramid. A nearly unbroken reign of economist-chairmen—Burns, Volcker, Greenspan, and now Bernanke—has characterized modern Fed history. Having an economist at the top does not necessarily translate into better policy, but it does make the policy regime more understandable in terms of economic theory.

The one short gap—between the Keynesian-oriented Burns and the monetarist-oriented Volcker—was bridged by the unlikely G. William Miller (March 1978–August 1979). Appointed by President Carter and somehow confirmed by the Senate, Miller was a marine engineer turned lawyer. He was a long-time executive of Textron, Inc., and, on several occasions, had served the Carter administration in an advisory capacity. Clearly out of his element, Miller oversaw the acceleration phase of that period’s double-digit inflation. Following established procedure for managing total bank reserves and hence deposit money, Miller and the other members of the Board (plus some Reserve Bank presidents) met about every month and a half to set short-term interest rates. They literally “set” the discount rate, the rate at which the Fed lends reserves directly to commercial banks, and they “targeted” (about which more below) the federal funds rate, the overnight rate at which commercial banks lend to one another for the purpose of meeting their reserve requirements, those requirements themselves having been imposed by the Fed.

During the 17 months of Miller’s tenure the discount rate was increased from 61⁄2 to 101⁄4 percent, the fed-funds target rate from 63⁄4 to 11 percent. Though responding to political pressures to keep interest rates low, the Miller Fed was constrained in each policy meeting by the inflation that had resulted from decisions in earlier meetings. With prices and wages rising at double-digit rates by the end of the decade, the Fed-controlled interest rates (both set and targeted) continued to rise in nominal terms, but were actually near zero or even negative in real terms. And as was well understood in financial and academic circles, holding nominal rates of interest below the inflation rate is a policy that cannot be sustained.

Finally, to stop the bleeding and to appease fiscal conservatives, Carter moved the chairman from the Federal Reserve to his own cabinet—where, as secretary of the treasury, Miller could borrow lots of money but couldn’t create any. Paul Volcker, then president of the New York Fed, was brought in as the new chairman of the Board. The circumstances under which Volcker assumed the chairmanship were unique and significant: (1) interest-rate targeting as a means of limiting inflation had lost its credibility. (2) Milton Friedman’s monetarism, which focused attention on the growth rate of the money supply rather than on short-term interest rates, was gaining acceptance in academic circles and beyond. And (3) the new Fed chairman had the support of fiscal conservatives both in Washington and on Wall Street.

In early October 1979, the Federal Reserve switched its modus operandi from fed-funds targeting to money-growth targeting. It never quite adopted Friedman’s monetary rule—according to which it should increase the money supply at a constant and pre-announced low-single-digit rate. But deliberations at the policy meetings were conducted in terms of money-growth rates rather than fed-funds rates. The money-growth rate and hence the inflation rate were brought down, while the fed-funds rate found its own level at record highs—topping out twice at 19 percent in 1981 and not returning to pre-Miller levels for several years.

As an episode in money-growth targeting, the so-called monetarist experiment lasted only three years (1979–1982). The key monetary aggregate, christened M1, was made up of coins, currency, and checking-account balances. M1 provided a solid anchor for money-growth policy at the beginning of the experiment, but the experiment itself led to a complete unanchoring of monetarism at the end. The story involves a heavy dose of monetarist irony.

The 1930s’ banking reforms that restricted policymaking to Washington also restricted the behavior of banks in critical ways. A Federal Reserve statute (Regulation Q) imposed key restrictions on demand deposits and time deposits. In effect, depositors were precluded from having a single account on which they could (1) write checks and (2) earn interest. The statute also set strict limits on savings-account interest rates. Though not implemented with money-growth targeting in mind, Regulation Q gave rise to a sharp distinction between money (that is, checkable accounts) and savings (that is, interest-earning accounts). This either-or aspect of money and savings allowed for a crisp definition of the money supply. M1 was money that people could actually spend and hence was unquestionably the basis for policymaking. The larger monetary aggregates (M2, M3, and still-more-encompassing M’s) included heavier and heavier doses of savings and thus were not so relevant to the issue of inflation.

And herein lies the monetarist irony. According to this free-market school of thought, the Federal Reserve can keep the economy performing at its laissez-faire best by ignoring interest rates and focusing instead on the money supply. But having a money-supply magnitude worthy of the Fed’s attention required this one critical departure from laissez faire called Regulation Q. Compounding the irony was the effect of the monetarist experiment on the viability of Regulation Q. As long as market interest rates hovered in the low single digits, the distortions caused by interest-rate ceilings (including a ceiling of zero percent on checkable accounts) were relatively minor. But the Miller Fed and subsequent monetarist experiment produced market rates of interest in excess of 20 percent, creating strong incentives for the banking industry to circumvent Regulation Q. The circumvention started with NOW accounts (Negotiable Order of Withdrawal), which were, in all but name, checkable savings accounts. Soon after, money-market mutual funds arose to help savers take advantage of the high treasury-bill rates. These and other such financial innovations threatened the very existence of commercial-bank savings accounts. The legislative reaction was bank deregulation, initiated during the Carter administration and accelerated in the early years of the Reagan administration. By 1982 Regulation Q was gone—and so too was the crisp distinction between checking accounts and savings accounts and the special significance of M1.

Though the Volcker Fed persistently missed its money-growth targets on the high side, it could claim to have done fairly well in dealing with inflation, at least in comparison to the Miller Fed. But in setting relatively low money-growth targets, it had destroyed (through high interest rates and bank deregulation) its ability even to identify a relevant money-supply magnitude. In 1982 the Volcker Fed reverted to targeting the fed-funds rate, not really by choice but because that was the only target left standing.

The Greenspan Era

When Alan Greenspan became Fed chairman on August 11, 1987, the interest-rate targeting continued. There was early and continued criticism of Greenspan because of his focus on interest rates rather than on monetary aggregates. As Bob Woodward reports in Maestro: Greenspan’s Fed and the American Boom (2000), the notion of money-supply targeting was still alive in 1989 in the person of Richard Darman, President George H. W. Bush’s budget director. Darman complained that Greenspan was mismanaging the money supply and, in particular, that the money-growth rate was too low. Greenspan responded dismissively with the claim that Darman had some sadly out-of-date notions. Without actually explaining to his readers just why those monetarist notions were out of date, Woodward remarked, “The Fed couldn’t even measure the money supply accurately, let alone control it” (p. 63).

As was true before the short period of money-supply targeting, the only interest rate that the Federal Reserve could actually get in its crosshairs was the fed-funds rate. That rate comes highly recommended as a target if the only criterion is the answer to the question “Can the Fed actually aim at—and hit—the target?” The answer is yes. The Fed can add to (or subtract from) bank reserves by buying (or selling) treasury bills. When the trading desk at the New York Fed buys a treasury bill from a commercial bank, the bank’s earning assets are reduced by the value of the treasury bill and its reserves (funds not lent out) are increased by that same amount. (Key to understanding these open-market operations, as they are called, is the fact that, unlike ordinary purchasers of treasury bills, the Federal Reserve buys treasury bills with funds that were not in existence before it made the purchase. It spends new money into existence.) And because the fed-funds rate is the rate that governs interbank transactions made on an overnight basis (as banks with excess reserves lend to banks with reserve deficiencies), the impact of increased reserves on the fed-funds rate is immediate. The timely feedback observed by the Fed’s trading desk allows it to adjust the volume of treasury bills bought or sold so as to achieve the targeted fed-funds rate. The Federal Reserve is never very far off target on any given day. On the basis of weekly averages, the Fed’s aim looks even better, and on the basis of monthly averages, the Fed scores a bull’s-eye every time.

Hitting the chosen fed-funds rate is not a problem. But choosing the particular fed-funds rate to target is another matter. Some choices are clearly non-viable, as was roundly demonstrated by the Miller Fed. Targeting too low a fed-funds rate requires a large infusion of reserves, which gives rise to a dramatically increasing money supply, which causes substantial inflation, which puts an inflation premium on all interest rates, which precludes the Fed’s having such a low target rate. The Miller Fed persistently failed to raise its target rate enough to keep up with the rising inflation premium.

Targeting too high a fed-funds rate might require a shrinkage of reserves, which would force a monetary contraction and put the economy into recession, weakening the business community’s demands for loans and hence reducing market rates of interest. The targeted fed-funds rate that was already too high is thrown even further out of line with actual market conditions.

Unfortunately for central banking, there is a wide spectrum of potential fed-funds target rates between clearly too low and clearly too high. Here, the root problem faced by the Fed is no different from the problem associated with a more general central control of economic activity. The Food Czar of a command economy can easily conceive of too many chickens or too few chickens. But the Goldilocks number of chickens—like the Goldilocks fed-funds target rate—doesn’t identify itself. Of course, in a thoroughly decentralized economy, it is the market-determined price of chickens—and the market-determined interest rates—that keep the economy functioning smoothly.

In choosing a fed-funds target rate, Greenspan’s thinking—at least early in his reign as Fed chairman—seemed to acknowledge the significance of having a rate that was just right. Referring to a 1989 episode, Woodward accurately captures Greenspan’s view: “[T]he Fed’s interest-rate policy had to be credible. A particular fed-funds rate had to be seen by markets as the best rate for the economy, not as an artificially low rate influenced by political pressure” (p. 62). Here, we see not only a bow to the market economy but a teasing hint at the Mises-Hayek theory of the business cycle: Holding interest rates artificially low sets the economy off on an unsustainable growth path. The policy-induced boom eventually ends in a bust. To avoid boom and bust, resources had to be allocated on the basis of the “natural rate of interest,” so named by Swedish economist Knut Wicksell and adopted as the market benchmark by Mises and Hayek.

Unfortunately, the very existence of a central bank precludes its knowing what the natural rate of interest is. That rate is the rate that would prevail “naturally,” that is, as the result of the give and take of decentralized forces in the absence of a central bank. Whatever theoretical understanding Greenspan retained from his early studies in Austrian economics, his practical approach to managing the monetary system was very conventional: raise the fed-funds target to counter inflationary pressures; lower the fed-funds target to counter unemployment.

Too High for Politics

While keeping with convention, interest rates were kept too high for George H. W. Bush’s political purposes in the 1992 presidential campaign. That was the claim made by the Republican leadership—and the reason for the widely perceived bad blood between Bush and Greenspan. But Greenspan was not always blind to political objectives. He signed on as a team player early in the Clinton administration and played a strong supporting role in Clinton’s 1996 campaign. Clearly (in retrospect and even at the time) the Fed’s lowering of the fed-funds target rate early in that election year was intended to counter the Republican Party rather than to counter unemployment.

While departing from the principles of central banking to give the Clinton campaign an edge, Greenspan departed from his Austrian roots in explaining the mid-to-late-1990s boom. He articulated a theory—or, at least, a belief—that ran completely counter to the Austrian theory. As reported by Woodward (pp. 171ff.), Greenspan persistently held to the belief—though a belief without proof—that productivity had increased on an economywide basis, creating what was popularly called the “New Economy.” Higher productivity would mean increasing output, which would hold price and wage inflation in check even as the Fed pursued an easy-money policy.

Greenspan’s calculations, however, are especially revealing. Inexplicably, he made his estimates of the supposed increase in productivity on the basis of the assumption that non-labor costs are constant. Surely, though, this is a peculiar assumption for the Fed chairman to make in light of the fact that non-labor costs include the cost of borrowing, which are affected rather dramatically by Fed policy. Lower borrowing costs—a.k.a. artificially low rates of interest—get reflected in increased profits for a wide variety of business firms. If non-labor costs are (counter to fact) assumed to be constant, then those increased profits will be mistakenly seen as evidence of a general increase in labor productivity. But since productivity gains are rarely across-the-board gains, it is much more likely that what Greenspan was observing was not some New Economy at all but rather the Old Economy goosed up by credit expansion.

In any case, the economywide downturn that began in late 2000 put an end to both the Clinton-Greenspan expansion and the so-called New Economy. Perhaps the only thing new about that period was the increasing irrelevance of the monetary aggregates. As already indicated, the once-all-important M1 had lost much of its significance with the 1980s monetary deregulation and in particular with the phasing out of Regulation Q. But during the increased globalization of the 1990s, this one-time key monetary magnitude lost virtually all its significance. As M1 actually declined from the mid-1990s through the turn of the century, its currency component rose dramatically. The ratio C/M1 rose from well below 30 percent at the beginning of the Greenspan years to well over 50 percent at the end—with most of that increase occurring during the last half of the 1990s. The dramatic change reflected not the increased use of currency in the United States but the increased use of U.S. currency outside our borders. Stashes of dollars in unstable Middle Eastern countries as well as the widespread circulation of dollars in former Soviet-bloc countries and in Latin American countries that have become (officially or unofficially) dollarized help account for the high demand of U.S. currency.

Friedman’s monetarism and especially his monetary rule, as articulated with the aid of the bedrock equation of exchange (MV = PQ), requires that the M and the P and the Q all refer to the same piece of geography. It just won’t do, for instance, to take P and Q to be the U.S. Consumer Price Index and the U.S. Gross Domestic Product and to take the corresponding M to be M1—much of which is outside the United States. But the Federal Reserve has no way of tabulating M1US. That is, Greenspan knew how much M1 had been created, but he didn’t know where in the world it was. Trying to manage the money supply directly, then, that is, adopting a policy of money-supply targeting, was increasingly problematic. More so than ever, fed-funds targeting was all there was to do.

“Neutral Interest Rate”

Fed watchers during the last years of Greenspan’s chairmanship have repeatedly encountered the term “neutral rate of interest” in discussions of the Fed’s choice of fed-funds target rates. That term could be taken as evidence that Greenspan had returned to his Austrian roots and wanted to target a fed-funds rate consistent with the “natural rate of interest,” that is, the rate of interest that would prevail in a market unhampered by a central bank. But “Greenspan-neutral” is not the same thing as “Austrian-natural.” The Fed knows that if it sets interest rates too low, there will be worries about inflation, and if it sets interest rates too high, there will be worries about unemployment. The goal, then, is to balance the worries—that is, to find the equi-worry fed-funds rate. That’s what’s meant by the neutral rate.

But just whose worries count? The worries emanating from financial markets? Traders in financial markets might worry about interest rates being too low or too high—but mainly because of the implications about future actions by the Federal Reserve. Is the Fed going to raise rates? Is it going to lower them? The neutral fed-funds rate, then, would be the rate that causes the financial markets to have no net worry about the fed-funds rate changing in one direction or the other. If this is the balancing act that underlies Federal Reserve policy, then both the Fed and financial markets are living in a house of mirrors.

Is there any known market mechanism that causes the neutral rate to be brought into line with the natural rate? That is, is there any reason to believe that equi-worry about inflation and unemployment translates into interest rates that are consistent with sustainable growth? Or is it quite possible that the Greenspan-neutral rate lies below the Austrian-natural rate? We have the answer to this question from Greenspan himself—as summarized by Woodward: “There was no rational way to determine that you were in a bubble when you were in it. The bubble was perceived only after it burst . . .” (p. 217). Evidently, the equi-worry rate itself is something to worry about.

On the last day that Alan Greenspan served as Fed chairman, Milton Friedman penned a commentary in the Wall Street Journal (January 31, 2006) titled “He Has Set a Standard.” Some readers of the WSJ might have been led to believe that Greenspan had somehow followed Friedman’s monetary rule. We now see, though, that there was no well-grounded rule; there was no standard. In truth, Greenspan pitted worry against worry and was lucky enough to make it to the end of his final term despite there being no standard at all.

And now, Ben Bernanke has pledged to continue the policies of the Greenspan Fed—possibly with a little less worry about inflation. We can only wonder how long his luck will hold out.

Do busts follow investment booms as hangovers follow drinking binges? Dubbing the idea “The Hangover Theory” (Slate, December 3, 1998), Paul Krugman has attempted to denigrate the business-cycle theory introduced early last century by Austrian economist Ludwig von Mises and developed most notably by Nobelist F. A. Hayek.

Yet proponents of the Austrian theory have themselves embraced this apt metaphor. And if investment is the intoxicant, then the interest rate is the minimum drinking age. Set the interest rate too low and there is bound to be trouble ahead.

The metaphorical drinking age is set by—and periodically changed by—the Federal Reserve. In our Fed-centric mixed economy, the understanding that “the Fed sets interest rates” has become widely accepted as a simple institutional fact. But unlike an actual drinking age, which has an inherent degree of arbitrariness about it, the interest rate cannot simply be set by some extra-market authority. With market forces in play, it has a life of its own.

The interest rate is a price. It’s the price that brings into balance our eagerness to consume now and our willingness to save and invest for the future. The more we save, the lower the market rate. Our increased saving makes more investment possible; the lower rate makes investments more future-oriented. In this way, the market balances current consumption and economic growth.

Price-fixing foils the market. Government-mandated ceilings on apartment rental rates, for instance, create housing shortages, as is well known by anyone who has gone apartment hunting in New York City. Similarly, a legislated interest-rate ceiling would cause a credit shortage: The volume of investment funds demanded would exceed people’s actual willingness to save.

But the Fed can do more than simply impose a ceiling on credit markets. Setting the interest rate below where the market would have it is accomplished not by decree but by increasing the money supply, temporarily masking the discrepancy between supply and demand. This papering over the credit shortage hides a problem that would otherwise be obvious, allowing it to fester beneath a binge of investment spending.

An artificially low rate of interest, then, sets the economy off on an unsustainable growth path. During the boom, investment spending is excessively long-term and overly optimistic. Further, high levels of consumer spending draw real resources away from the investment sector, increasing the gap between the resources actually available and the resources needed to see the long-term and speculative investments through to completion.

Save more and we get a market process that plays itself out as economic growth. Pump new money through credit markets and we get a market process of a very different kind: It doesn’t play itself out; it does itself in. The investment binge is followed by a hangover. This is the Austrian theory in a nutshell. (Ironically, it is the theory that Alan Greenspan presented 40 years ago when he lectured for the Nathaniel Branden Institute.) We believe that there is strong evidence that the United States is now in the hangover phase of a classic Mises-Hayek business cycle.

In recent years money-supply figures (M1, M2, etc.) have become clouded by institutional and technological change. But in our view, a tale-telling pattern is traced out by the MZM data reported by the Federal Reserve Bank of St. Louis. ZM standing for “zero maturity,” this monetary aggregate is a better indicator of credit conditions than are the more narrowly defined M’s.

Credit-Creation Binge

After increasing at a rate of less than 2.5 percent during the first three years of the Clinton administration, MZM increased over the next three years (1996–1998) at an annualized rate of over 10 percent, rising during the last half of 1998 at a binge rate of almost 15 percent.

Sean Corrigan, a principal in Capital Insight, a UK-based financial consultancy, details the consequences of the further expansion that came in “autumn 1998, when the world economy, still racked by the problems of the Asian credit bust over the preceding year, then had to cope with the Russian default and the implosion of the mighty Long-Term Capital Management.”

Corrigan goes on: “Over the next eighteen months, the Fed added $55 billion to its portfolio of Treasuries and swelled repos held from $6.5 billion to $22 billion… [T]his translated into a combined money market mutual fund and commercial bank asset increase of $870 billion to the market peak, of $1.2 trillion to the industrial production peak, and of $1.8 trillion to date [August 14, 2001]—twice the level of real GDP added in the same interval” (http://mises.org/fullarticle.asp?control=754).

The party was in full swing. The Fed cut the fed funds rate 100 basis points between June 1998 and January 1999. The rate on 30-year Treasuries dropped from a high of over 7 percent to a low of 5 percent. Stock markets soared. The NASDAQ composite went from just over 1000 to over 5000, rising over 80 percent in 1999 alone. With abundant credit being freely served to Internet start-ups, hordes of corporate managers, who had seemed married to their stodgy blue-chip companies, suddenly were romancing some sexy dot-com that had just joined the party.

Consumer Spending Strong

Meanwhile consumer spending stayed strong—with very low (sometimes negative) savings rates. Growth was not being fueled by real investment, which would require forgoing current consumption to save for the future, but by the monetary printing press.

As so often happens at bacchanalia, when the party entered the wee hours, it became apparent that too many guys had planned on taking the same girl home. There were too few resources available for all of their plans to succeed. The most crucial—and most general—unavailable factor was a continuing flow of investment funds. There also turned out to be shortages of programmers, network engineers, technical managers, and other factors of production. The rising prices of these factors exacerbated the ill effects of the shortage of funds.

The business plans for many of the start-ups involved negative cash flows for the first ten or 15 years while they “built market share.” To keep the atmosphere festive, they needed the host to keep filling the punch bowl. But fears of inflation led to Federal Reserve tightening in late 1999, which helped bring MZM growth back into the single digits (8.5 percent for the 1999–2000 period). As the punch bowl emptied, the hangover—and the dot-com bloodbath—began. According to research from Webmergers.com, at least 582 Internet companies closed their doors between May 2000 and July 2001. The plunge in share price of many of those still alive has been gut wrenching. The NASDAQ retraced two years of gains in a little over a year.

During the first half of 2001, the Fed demonstrated—with its half-dozen interest-rate cuts and a near-desperate MZM growth of over 23 percent—that you can’t recreate euphoria in the midst of a hangover.

It all adds up to the Austrian theory. As a final twist to our story, we note that Krugman, who previously could only mock the Austrians, has recently given us an Austrian account of our macroeconomic ills. In his “Delusions of Prosperity” (New York Times, August 14, 2001), Krugman explains how our current difficulties go beyond those of a simple financial panic:

We are not in the midst of a financial panic, and recovery isn’t simply a matter of restoring confidence. Indeed, excessive confidence [fostered by unduly low interest rates maintained by rapid monetary growth?] may be part of the problem. Instead of being the victims of self-fulfilling pessimism, we may be suffering from self-defeating optimism. The driving force behind the current slowdown is a plunge in business investment. It now seems clear that over the last few years businesses spent too much on equipment and software and that they will be cautious about further spending until their excess capacity has been worked off. And the Fed cannot do much to change their minds, since equipment spending [at least when such spending has already proved to be excessive] is not particularly sensitive to interest rates.

With Krugman on the verge of rediscovering the policy-induced self-reversing process that we call the Austrian theory of the business cycle, we confidently claim that current macroeconomic conditions are best described as a classic Hayekian hangover. The Austrian theory, of course, gives us no policy prescription for converting this ongoing hangover into renewed euphoria. But it does provide us with the best guide for avoiding future ones.

Reviewed by Roger W. Garrison

It may not be conventional to review the fifth edition of a book that appears several years after its author’s passing. But America’s Great Depression is not a conventional book. It is written with verve and aplomb. And its rendition of the Austrian theory of the business cycle, critique of alternative theories, and detailed history of the early part of the Great Depression (1929–1933) have captured the attention of a small but growing group of students and researchers for nearly four decades.

Each of the five editions has had a different publisher, the first four with an introduction by the author. With the fifth edition, we get a quality hardback, new typesetting with footnotes instead of endnotes, and a spirited introduction by historian Paul Johnson. A new dust jacket is fashioned from a photograph showing throngs of men in winter coats and fedoras standing despondently in line and casting long shadows. The image cries out for an explanation: How could things have gone so wrong?

The Great Depression has cast a long shadow of its own over twentieth-century economic history and policy issues. In many circles—even academic circles—it is still acceptable simply to point to the experience of the 1930s as clear evidence that market economies are prone to collapse. Rothbard provides an alternative understanding. Unsound policies of the central bank set the economy off on an unsustainable growth path in the 1920s, creating the conditions for the crash at the end of that decade. Attempts by the government to undo or mitigate the damage only made matters worse.

The excesses of the twenties, the downturn, and the dramatic slide into deep depression are all traced to governmental disruptions of the market process.

Reasserting the Austrian view of boom and bust, the initial publication of America’s Great Depression had a certain strategic significance. Through the 1930s and into the early 1940s, F. A. Hayek had contributed importantly to our understanding of business cycles but then abandoned the topic in favor of the broader issues of political economy. Rothbard offered the Austrian view anew in 1963. America’s Great Depression stood as a complement to the relevant chapters of Ludwig von Mises’s Human Action, issued in a revised edition that same year, and as a supplement to Rothbard’s own Man, Economy, and State, which had been published the year before.

Equally significant in 1963 was the book’s contrast with competing views of the events of the interwar period and its relationship to the general development of macroeconomic thought. In that same year, Milton Friedman and Anna Schwartz published their Monetary History of the United States: 1867–1960. They too blamed the Federal Reserve for the Great Depression. However, the central focus in their treatment of the episode was the collapse of the money supply (1929–1933) that took the economy into deep depression. There was no suggestion that during the previous boom, credit expansion had caused interest rates to be artificially low and hence had caused resources to be systematically misallocated in a way that would eventually require liquidation and reallocation. To the contrary, the nearly constant level of prices throughout the twenties was taken as a sign of macro-economic health.

Rothbard showed that policy-distorted interest rates give rise to a mismatch between the intertemporal production plans of entrepreneurs and the preferences of consumers, the latter being expressed by people’s willingness to save. With the central bank’s policy of cheap credit, more investment projects are initiated than can actually be completed. Too many resources are committed to the early stages of production, leaving insufficient resources for the late stages. The artificial boom is destined to end in a bust.

But wasn’t it the subsequent collapse of the money supply that converted the bust into deep depression? Rothbard says no, pointing out that the Federal Reserve, instead of trying to reflate in the early 1930s, should have deliberately deflated—“to bolster confidence in gold” and to “speed up the adjustments needed to end the depression.” With this argument, he dismisses the monetarists’ concern about monetary deflation and about the resulting economywide discoordination that accompanies the piecemeal downward adjustment of prices. (Then and now, some of Rothbard’s readers would acknowledge the harmful effects of monetary collapse—though without this acknowledgment detracting from the key Austrian insights about the nature of the initial downturn.)

Blaming business cycles on government was a hard sell in the 1960s—the decade in which Keynesianism ruled supreme—both in the seats of power and in the halls of academe. Rothbard is to be credited for keeping alive (during a period when the Austrian school was almost completely in eclipse) the key ideas about how the market process goes right if left on its own and how it goes so wrong when the central bank induces more growth than savers are willing to finance.

In the introduction to the fourth edition, Rothbard remarked that interest in his book on business cycles itself exhibited a cyclical pattern. Each subsequent edition was published during a period of macroeconomic disorder—high unemployment, high inflation, or both. His final introduction was written during the inflationary recession of the early 1980s. Since that time, the economy has experienced almost uninterrupted economic expansion. It seems fitting that the fifth edition appears at the end of a record-breaking expansion that is widely attributed to the pro-growth policies of the central bank.

The “cycle” as applied to twentieth-century fluctuations—and to 21st-century worries—is better described as a boom-bust sequence. It is a whipsaw effect with no necessary recurrence implied. The economy is somehow set off on an unsustainable growth path—a path on which market forces are pitted against one another. Eventually and inevitably, the tradeoff between maintaining an excessively high growth rate and accommodating people’s current demands for consumables is made in favor of the latter. When resources are finally diverted away from the future-oriented investment projects, jobs are lost and a period of liquidation ensues.

The most conspicuous enduring characteristic of the boom-bust sequence is revealed by investigating the originating “somehow.” The origin of this macroeconomic misstep must have an essential element of centrality about it. A fully decentralized economic system cannot “somehow” set itself off on an unsustainable growth path. Such a systematic distortion suggests central decision-making, and the central element of note in our economic system is of course the central bank.

Credit expansion by the Federal Reserve orchestrates a boom. Abundant credit at artificially low rates of interest encourages more investment activity than can be carried through to completion. Entrepreneurs borrow the new money and buy resources. If the central bank had the power to print more resources too, the boom would be sustainable. But neither the Federal Reserve nor any other governmental institution has such powers. Hence, the boom is artificial and leads to a bust.

Beyond its origins in ill-conceived or politically motivated monetary policy, the boom-bust sequence has other enduring characteristics, such as excessive investment in long-term projects and dramatic movements in the prices of interest-sensitive and highly speculative assets. One curiously enduring complement of a maturing boom is the widely held belief that business cycles are a thing of the past. In the 1920s Irving Fisher believed we had reached a new plateau of prosperity. References to the “new economy” in today’s financial press should be seen as dark reminders of Fisher’s plateau. Editorials sounding related themes (“Conquering the Business Cycle”; “Have the Laws of the Cycle Been Repealed?”; “An Era of Cycle-Free Growth”) should be read as old hat rather than new era.

Even the reasons offered for believing that we’ve entered a new economy, while different in their details, are tellingly similar. The expansion of the 1990s actually involved real economic growth—attributable to the Internet, the digital revolution, and just-in-time inventory management. True enough, but the expansion of the 1920s also involved real economic growth—attributable to technological advancements in automobiles, home appliances, and food processing.

In both periods the real growth, which in the absence of credit expansion would have been accompanied by price reductions, helped keep price inflation in check. That is, increases in the money supply and the ongoing real economic growth had largely offsetting effects on the overall level of prices. F. A. Hayek described this circumstance as artificial price-level stabilization—a term that could only be puzzling to Irving Fisher and modern-day monetarists, who take price-level stability as the hallmark of macroeconomic health. But Hayek demonstrated that the absence (or slightness) of price inflation is of little comfort in a period when cheap credit is stimulating investment beyond people’s willingness to save. Price-level constancy does not equal macroeconomic stability.

The Art of Fed Watching

Business cycles aren’t what they used to be if only because some people—and policymakers—make judgments and take actions on the basis of their experience with previous booms and busts. The history of the art of “Fed watching” illustrates the point. During the early years of the Federal Reserve, there were no Fed watchers.

In fact, there was precious little that one could have watched. Data on the monetary aggregates and credit conditions were not readily available—a circumstance that helps explain how the boom (the monetary deception) could be so long-lasting.

During the 1960s and 1970s the availability of data on the key money-supply aggregates allowed Fed watchers to monitor its efforts to manipulate credit conditions. And in the early 1980s, when money-growth targeting replaced interest-rate targeting, those same aggregates allowed Fed watchers to compare track records to intentions and to make predictions about the Fed’s habitual overshooting. This was a period of relatively short business cycles.

In today’s environment, the monetary aggregates have lost the meaning they once had. The much-watched M1 and M2 derived their significance from two vital links: (1) the ability of the Federal Reserve to control those aggregates by adjusting the monetary base and (2) the near-constancy of the velocity of money, which maintained a near-constant ratio between the money supply and the price level. After extensive banking reforms severely weakened both links, the Federal Reserve returned to interest-rate targeting.

Present-day Fed watchers can only watch and wonder. The monetary aggregates are readily available but not very helpful. M1 is essentially the same as it was a year ago. Over that same period, M2 has risen by 8 percent and the new MZM has risen by 13 percent. (The “ZM,” which stands for zero maturity, indicates all financial instruments payable at par on demand.) Unfortunately, none of these money aggregates are both readily controllable and strongly correlated with the price level or any other macroeconomic variable.

Currently, there is timely information about the Federal Reserve’s changing interest-rate target. Both the administered discount rate and the targeted federal funds rate are publicly announced within a couple of hours of each decision to change them. What is not known, however, is the interest rate that would prevail in the absence of credit-market management by the Federal Reserve. The all-important “natural rate of interest”—like the “natural rate of unemployment”—becomes unobservable in a Fed-dominated environment.

Our suspicions of political motivation—along with the 13 percent MZM growth—suggest that the managed rates (of interest and unemployment) are somewhere below the respective natural rates. If so, the resulting pattern of investments is unsustainable; the economy is living on borrowed time. It’s a familiar story. The Internet and MZM notwithstanding, business cycles are what they used to be: The central bank has whipsawed the economy once again.

The most fundamental criticism of Keynesian economics has been offered by those who embrace the opposite vision: markets are inherently stable; the government is the destabilizer. This was the view of Ludwig von Mises and F. A. Hayek. The evidence of more than a half-century of failed “stabilization policy” strongly supports the Mises-Hayek view. The Keynesians can persist only by arguing that particular countercyclical measures were too weak or implemented too late. Underlying the whole debate, however, is a fundamental and enduring conflict of visions—to use the title concept of Thomas Sowell’s 1987 book.

Writing for the New York Times (Week in Review, August 22, 1999), Louis Uchitelle asks, “Who You Gonna Call After the Next Bust?” His answer—and those of the authorities on whom he relies—are Keynesian in the most fundamental sense. Note the vision-bound assessment of Robert Pollin (University of Massachusetts): “[Markets] can’t cure themselves. We will have to acknowledge that we need government for that. It’s the stabilizer.” And note that Princeton’s Alan Blinder imputes the Keynesian vision to the public: “In the event of a recession, people turn to Government en masse.”

Though there is dispute at the most fundamental level, there can be agreement about the likely course of the economy in the months or years ahead. According to Uchitelle, “the eight-year expansion walks on precarious legs, and when it collapses, getting the American economy back on its feet could be surprisingly hard and painful.” No doubt. But why, specifically, do we say the legs are precarious? And who, exactly, is supposed to be surprised that recovery will be hard and painful?

Uchitelle writes that “The strengths of this expansion are potentially destructive.” (Read: Strengths are weaknesses; the market is inherently unstable.) He sees precariousness in the fact that “the current expansion is fueled by private-sector debt.” Fueled? The Keynesian notion that the government can “fuel” the economy (“goose” the economy would be more apt) by deliberately spending more than it taxes has been uncritically transplanted to the private sector: “It is deficit spending that stimulates an economy, whether it comes from the private or public sectors.” Particularly troublesome, according to Uchitelle, is the prospect that the private-sector stimulant will turn into a public-sector handicap when the bubble bursts. The government will then have to resort to deficit finance to stimulate an already debt-wracked private sector. It is as if the government “were starting a one-mile race from 100 yards behind the starting line.”

Economists who understand the market’s self-stabilizing properties find no special significance in private-sector debt. It doesn’t fuel; it doesn’t stimulate; it doesn’t signify precariousness. Private-sector debt is simply the sum total of the indebtedness of many business firms and individual entrepreneurs. Most have borrowed on the basis of sound judgment and a healthy grasp of their particular economic circumstances. The profits they earn will put them in command of even more resources in the months and years ahead. Some, though, have borrowed on the basis of faulty judgment. They will incur losses and will find themselves in command of fewer resources. This is the nature of the market process; this is the system of profit and loss.

Sign of a Problem

Exonerating private-sector debt per se does not mean that this debt is never a symptom of a problem. But what is the underlying problem? What accounts for the increased level of indebtedness noted by Uchitelle? Is it a credit expansion engineered by the central bank? Is it banking legislation that has encouraged financial institutions to take undue risks while the FDIC continues to provide deposit insurance at subsidized rates? Is it the too-big-to-fail doctrine that has guided regulators in dealing with overextended financial institutions?

It is, of course, all of the above. Centrally orchestrated credit expansion is the cause of boom and bust as spelled out by Mises and Hayek. Externalizing risks and subsidizing risk-taking behavior is another way of fostering an unsustainable boom. And the standard classical case for the system of profit and loss does not fully apply to a system of profit and too-big-to-fail. To recognize these aspects of our mixed economy is to understand that it is because of government policy that the private sector “walks on precarious legs.”

Though not noted by Uchitelle, a clear indicator of “precariousness” is the market’s perverse reaction to seemingly good economic news. Nowadays, when the unemployment rate goes down, speculators turn bearish. Why so? Isn’t lower unemployment a good thing? One view has it that the current unemployment rate (about 4.2 percent) is unsustainable, because it is significantly below the so-called natural rate of unemployment (generally believed to be 5 to 6 percent). The alternative view is that the natural rate itself has fallen.

In an unregulated market economy, the question of which view is correct would be an idle one. But if a central bank is in charge of stabilizing the economy, the question takes on critical significance. Which view does the central bank think is correct? And what are the policy implications? With each movement of the unemployment rate, speculators reform their expectations about what the Fed is likely to do and when it is likely to do it. A central bank trying to manipulate the market while the market tries to anticipate and hedge against the central bank’s actions is not a recipe for macroeconomic stability.

So, who you gonna call after the next bust? If government is the destabilizer, it makes little sense to turn to that same government for stabilization. But the Keynesian economists are sure to make that very call, and the government is sure to respond. Recovery will be hard and painful. Who, though, will be surprised? Not the students of Mises and Hayek.

According to Pollin, acknowledging that we need government to provide stability “will open up a broader debate about what government should do.” Uchitelle has some ideas of his own here. The Federal Reserve, he argues, has had primary responsibility for stabilizing the economy over the past 20 years. It lowers interest rates when the economy begins to falter and encourages the private sector to take on more debt. Now, with private-sector debt at worrisome levels, we need to shift the emphasis from monetary policy to fiscal policy. Uchitelle sees room for old-line Keynesian programs: “More government spending on housing, public works, education and income subsidies seems likely to accompany the next recession.”

Students of Mises and Hayek would opt for decentralizing the monetary system rather than calling on the central fiscal authority to aid and abet the central monetary authority. But no. Suddenly, it’s 1936 again. Keynesian-ism is back—and in its rawest form.

This assessment was offered up late last year in the online magazine Slate by Paul Krugman, 1991 winner of the prestigious John Bates Clark Award.

A few weeks before Krugman wrote that, Gene Epstein, economics editor of Barron’s, profiled this Yale-bred, MIT-based economic theorist. Epstein’s article was largely positive and wholly respectful. But in a mildly critical tone, Epstein wondered if Krugman hadn’t committed an error of omission. His writings on recessions seemed to suggest that he knew little or nothing about Hayek’s theory of the business cycle, a theory built on the cumulative efforts of Carl Menger, Eugen von Böhm-Bawerk, and Ludwig von Mises. Krugman conceded that he wasn’t familiar with the Austrian theory.

One is reminded of the notorious episode in which John Maynard Keynes reviewed Mises’s Theory of Money and Credit, which was published in German. He faulted Mises for failing to offer anything original and then later remarked that when he read German, he understood only what he already knew. If we get our appreciation of Hayek through Krugman, we can credit Hayek for very little. Unlike Keynes, though, Krugman cannot invoke language as an excuse. Hayek did not get the Nobel Prize for his political views; he got it for his work on business-cycle theory. Why would Krugman not be completely familiar with Hayek’s contributions? Stay tuned.

Clearly not a follower of Austrian theorizing, Krugman is, if anything, a quick study. On the same occasion in which he denied Hayek any standing as an economic theorist, he launched a vitriolic attack on the Austrians and their “hangover theory” of recessions. “I regard [their theory] as being about as worthy of serious study as the phlogiston theory of fire.” Though he failed to identify the Barron’s article or its author as the spark that set off this firestorm, he was clearly reacting to Epstein.

“Hangover theory” is a term obviously intended to denigrate the Austrian account of the unsustainable boom. Yet it is descriptive of many—if not most—modern business-cycle theories. The idea that booms lead to busts as drinking binges lead to hangovers is at home in both Monetarism and New Classicism. Even our sophomore-level college textbooks feature a stilted version of the hangover theory. In the late 1970s, the analogy between the abuse of monetary tools and the abuse of illegal substances became so well understood in the financial world that the argument by analogy was nearly reversed. A memorable cartoon of the period showed a balding Wall Street banker having a heart-to-heart with his errant teenage son: “Think of it this way, Timmy: Taking drugs is kinda like increasing the money supply. . . .”

The Austrian hangover is unique. The misallocation of resources during the period of artificially cheap credit has the feel of genuine growth, but these good feelings are followed by bad ones. The commitment of too many resources to projects that will yield output only in the remote future has as its counterpart an undue scarcity of resources for producing output in the near and intermediate future. In time the misallocation becomes apparent, after which follows a period of liquidation and reallocation—in a word: a recession.

None of this is to deny that a sharp increase in money demand (or a collapse in the money supply) can seriously retard recovery—as certainly happened in the 1930s. But Krugman would have us believe that monetary disequilibrium is the whole story: People, for some reason, want to hold more money than currently exists. Accordingly, his solution is simply to print the money up and let them hold it.

Krugman’s view of recessions is best put in perspective by comparing it with the contrasting views of Keynes and Hayek. These arch-rivals of the 1930s were in agreement that the increase in money demand, the “scramble for liquidity,” was a secondary aspect of the downturn but in disagreement about what the primary problem was. Keynes thought it was investment demand, which in a decentralized economy is prone to collapse. Hayek thought it was malinvestment induced by shortsighted or politically motivated actions of the central bank. [Editor's note: See Richard Ebeling's article, p. 28.] Krugman elevates what both Keynes and Hayek saw as a secondary aspect to the status of the primary problem. And then, creating difficulties for the historian of thought, he attributes the high-money-demand theory of recessions to Keynes himself.

Presumably rejecting all hangover theories, Krugman pronounces the Austrian variety “intellectually incoherent”—largely on the basis of a telling question: “[How can] bad investments in the past require the unemployment of good workers in the present?” Krugman’s implicit answer: They can’t—and therefore we needn’t pay any attention to Hayek. (The question itself is a good one and is likely to find its way onto macro exams at Auburn University.)

Emphasizing the time element in the economy’s capital structure, a Hayekian would argue that investment involves the employment of resources in a particular sequential pattern. During the downturn, good workers are out of work because the capital they need to work with is in short supply, having been committed to long-term projects now in need of liquidation. Krugman’s response (“Well, fine. Junk the bad investments and write off the bad loans.”) is all too facile. His advice is well taken, but the market process that implements it is time-consuming. During the junking and capital restructuring the demand for much of the labor force (labor whose capital complement has not yet been recreated) is low. And low demand translates into unemployment—except under the decidedly un-Austrian assumptions of instantaneous wage-rate adjustment and near-infinite labor mobility.

Recognizing that in Austrian theory the unemployment is somehow related to capital restructuring, Krugman poses another question: “Why doesn’t the investment boom—which presumably requires a transfer of workers in the opposite direction [from short-term projects to long-term projects]—also generate mass unemployment?” Gottfried Haberler asked the same question in his 1937 book, Prosperity and Depression. The answer is that during the cheap-credit boom, there is a net increase in labor demand. And because of the low interest rate, many workers are bid away from jobs in the late stages of production and into jobs in the early stages. During the downturn, however, there is a net reduction in labor demand. As liquidation gets underway, workers are released from the higher stages and (eventually) reabsorbed elsewhere in the economy.

Both of these future exam questions have been answered by drawing on Hayek’s contributions. Significantly, both answers involve heavy doses of capital theory, which serves as the underpinning of the Austrian theory of the business cycle. One seemingly permanent effect of the Keynesian Revolution was to tear macroeconomics loose from these underpinnings. Today, capital theory simply has no standing in mainstream macroeconomics. Accordingly, Hayek has no standing in the eyes of Krugman and other modern mainstream macroeconomists. It is a pity.

—Roger W. Garrison
Department of Economics
Auburn University