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Introduction to Austrian Economics
Podcast surveying the basic concepts of Austrian Economics.
Mr. Keynes’s Aggregates
Concealing the mechanisms of change.
One of F. A. Hayek’s most accurate, and oft-repeated, lines about John Maynard Keynes comes from a review of Keynes’s 1930 book, A Treatise on Money. Hayek wrote: “Mr. Keynes’ aggregates conceal the most fundamental mechanisms of change.” That Austrian macroeconomics rests firmly on the microeconomic “mechanisms of change” that ultimately comprise economic activity remains a crucial reason why that insight can better explain both the mistakes of the boom and the way out of the bust.
The Austrian insight is relevant to both capital and labor. In standard Keynesian models (as well as most other macroeconomic models), capital is understood as an undifferentiated mass. The Keynesian model also assumes that interest rates do not equilibrate the supply of savings and the demand for investment funds. Thus when people save more, there’s no signal transmitted to investors that they should build more for the future. As a result, the decline in consumption that accompanies the increase in savings causes firms to invest less as their inventories pile up without any offsetting increase in investment elsewhere due to the lower interest rate.
In the Austrian view investment cannot be treated at this high a level of aggregation. The production process that leads to consumption goods comprises a number of stages, starting with the “early” stages of research and development and raw materials, and finishing with the “later” stages, such as wholesaling or inventory management, which are closer to the final consumer purchase. Looking at the structure of production this way enables Austrians to note that when saving increases and causes interest rates to fall, resources will indeed be drawn away from the late-stage investments in inventory, but they will be drawn toward investment in early stages of production, as the interest lower rate makes longer-term production processes involving more stages relatively less costly. Over time, savings promotes those longer-term processes, which are more productive and provide us the capital base for economic growth.
By disaggregating investment, the Austrian model also reminds us that different kinds of capital goods have to “fit together” to be productive. This is most clear when central banks try to inflate to generate growth. In this case, the lower interest rates produced by excess money lead to increased investment in those same early stages. However, unlike the first story, where that increased investment is financed by reduced investment in the later stages, inflation also increases consumption as the lower interest rate reduces savings. The credit expansion creates no new resources but leads to more investment at both the very late and very early stages of production. This is the boom of the business cycle.
However, like a railroad being built, misaligned, from two directions, the plans of both sets of investors are unsustainable and the capital projects are left unfinished. We have a recession.
Labor Too
All that is true of capital here is also true of labor. Most Keynesian models also treat labor as an undifferentiated aggregate, speaking of “the” labor market and “the” wage rate. Once we look at the microeconomic processes underlying the structure of production, we see that each of these stages has its own labor market. Thus when resources move from one stage to another, the demand for labor will shift also, leading to changes in each wage rate. Growing sectors will attract labor, and shrinking ones lose it.
During an inflation-generated boom, labor, like capital, is misallocated across stages. And when the boom turns to bust, workers will lose their jobs as the projects they were working on are abandoned. Unemployment results as we enter the recession. However, that unemployment, like the misallocation of capital, will not be evenly distributed across the economy. To see the real costs of inflation-generated business cycles, we need to get behind the aggregates to see the fundamental mechanisms of change.
Being too focused on Keynes’s aggregates can also mislead us as to the best ways to get out of the recession once we’re in it. It may look as if all we need more is investment or more jobs. But once we understand that the “fundamental mechanisms of change” have to do with the boom’s microeconomic misallocation of capital and labor, we see that what is needed is a reallocation of resources not just more of them. Capital needs to move out of unproductive lines and back toward productive ones, and the same is true of labor.
Stimulus spending, bailouts, and extension of unemployment benefits only prevent the fundamental mechanisms of change from doing their work in unwinding the errors of the last decade. The cure for macroeconomic discoordination is freeing up the entrepreneurial market process to reallocate and coordinate resources. But 80 years after Hayek first made the point, the fascination by economists and politicians with Keynes’s aggregates continues to conceal the fundamental mechanisms of change, and in so doing, also continues to block the processes through which a sustainable recovery can take place.
Comment by Norman on 9 September 2010:
“But 80 years after Hayek first made the point” That’s the problem. Free market economists such as Hayek, Mises and yourself, have been predicting social disintegration from government intervention with the free market, but to the masses of people that has not occured, so they, along with their political leaders, consider interventionist economics as a panacea, while you worry about misallocation of capital across the stages of production. Perhaps after we’re long gone this will be evident.
Comment by Samuel Clemens on 9 September 2010:
“Perhaps after we’re long gone…” things will all work out. Eighty years is only part of the picture that has been evolving for more than 200 years in this country. Economics, liberty, and politics can not be divided. My whole life I have watched as this system has evolved, and thinking “Surely this system must collapse soon!” Yet we go on. Everyone works to one’s own advantage within the external system they face every day. This will be true whether that external system is “ideal” for the individual or not.
Comment by Dr Steve on 9 September 2010:
Steven, have you no “hope” from the “change” being imposed by the anointed elite( I’m currently reading Sowell’s Vision of the Anointed)? Mr. Obama has spoken with business men, he said so. Why, he might have played golf with some. He and the elite surrounding him know just what we need. And they will force feed us with it until we succumb.
Samuel, it is like bending a piece of metal. At first you can bend it back and things are O.K., but eventually fatigue sets in and it fails. Our economy will have that failure point, it is just a matter of time, unless we stop bending and bending……
Comment by Guillermo Barba on 9 September 2010:
As usual, it is an excellent article.
In terms of influencing policy behaviour there are at least two tasks. One, is to describe the roots of the present mess, which Prof. Horwitz deals with very clearly. The other, is to propose the policy actions needed in order to speed and soften as much as possible the transition to a healthier economic coordination. The mainstream’s framework, politicians, burocrats, most media, and rent seekers, which caused this mess, appear to the public be more concerned, progressive, and in a higher moral ground than the very few that ‘just’ expose that malinvestments need to be worked out.
Perceptions!
Comment by Scott Green on 10 September 2010:
As earlier posts note, many people have been expecting the decline of the US economy under the ever increasing weight of government control for a long time now. In predicting the timing of this decline, one shouldn’t underestimate the strength of the free market foundation that underlies the US economy; it can endure a substantial amount of government meddling and many parasitic hangers-on. Also, what seems like a long time in terms of a human lifespan is short in historical terms.
Indeed, the burdens on the US economy are growing at an accelerating rate, and the decline will occur – if it is not upon us now. The narrow perspective of our lifetimes makes watching this unfold all the more painful; the bringing down of a great nation seems to be occurring in slow motion.
Comment by Troy Camplin on 10 September 2010:
One of the features of a spontaneous order/complex adaptive system is that it is robust. It can take hit after hit, undergo periodic simplification, then reorganize and become more robust yet again. But this doesn’t mean that a relentless barrage of system-simplifying government interventions won’t eventually take their toll. Eventually the fat deposits (bureaucracy) and cancers (attempts to make everything the same) take their toll, and the body succumbs to disease. Our economy is sick now. It is sick because of the illnesses of government intervention. The body won’t recover quickly if the cancer is trying to make the body well. Only if the body recovers on its own — despite the actions of the cancer within it — will one get back to being healthy. But eventually the fat and cancer are bound to win. That is when death occurs. A body is very robust, but it will eventually succumb to the destructive forces of outside interventions.
Comment by Russ Nelson on 31 March 2011:
Norman, where is my flying car? Why does my health care cost so much? We are much poorer than we should be, or would be if the government would just get out of the way.
Pingback by Acertando ou percebendo o erro? | OrdemLivre.org on 1 June 2011:
[...] da teoria austríaca dos ciclos econômicos e como ela difere do keynesianismo em particular. Em um artigo anterior, tratei de alguns aspectos dessas diferenças, mas aqueles são apenas alguns dos muitos assuntos [...]
Pingback by Fearing Hayek | The Freeman | Ideas On Liberty on 9 December 2011:
[...] The Hayekian wing of the blogosphere (which has nothing to do with the right wing) has responded in force, and properly so. A common theme is that Hayek furnished the grounds for a proper skepticism about macroeconomics, the branch of economics launched by Keynes that treats large statistical aggregates (demand, unemployment, and so on) as though they were concrete entities that interact with each according to fixed quantitative rules rather than historical “summations” of individual human actions. As Hayek wrote, “Mr. Keynes’ aggregates conceal the most fundamental mechanisms of change.” (See Steven Horwitz’s “Mr. Keynes’s Aggregates.”) [...]
Pingback by Who’s Afraid of Friedrich Hayek? | Daily Libertarian on 9 December 2011:
[...] The Hayekian wing of the blogosphere (which really has nothing to do with the right wing) has responded in force, and properly so. A common theme is that Hayek furnished the grounds for a proper skepticism about macroeconomics, the branch of economics launched by Keynes that treats large statistical aggregates (demand, unemployment, and so on) as though they were concrete entities that interact with each according to fixed quantitative rules rather than historical “summations” of individual purposeful actions in a particular institutional context. As Hayek wrote, “Mr. Keynes’ aggregates conceal the most fundamental mechanisms of change.” (See Steven Horwitz’s “Mr. Keynes’s Aggregates.”) [...]
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[...] Steven Horwitz summed up the real prescription for economic recovery: Being too focused on Keynes’s aggregates can also mislead us as to the best ways to get out of [...]
Pingback by The Shrubbloggers » The Reign of Fonzie Economics on 10 December 2011:
[...] Steven Horwitz summed up the real prescription for economic recovery: Being too focused on Keynes’s aggregates can also mislead us as to the best ways to get out of [...]
Pingback by “The market” and “the economy” | Pirates, Politics, and the Pursuit of Happiness on 6 January 2012:
[...] since these terms conceal the true mechanics of change (they remove “the people” from the discussion, which is, after all, what we’re [...]
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