Finally, after years of economic turmoil, of boom and bust in the global economy, the great Austrian Friedrich von Hayek (1899-1992) is making an impact as the premier challenger of John Maynard Keynes and Keynesian policies of easy money, stimulus, and Big Government.
The real estate boom-bust cycle and the financial crisis of 2008 caused the academic world and government officials to search for a theory that explains asset bubbles and structural imbalances in the global economy, and the Austrian theory of the business cycle has suddenly come back into vogue.
Even the mainstream CFA Institute recently featured Austrian economics in its study materials for the Level 1 exam for would-be Chartered Financial Analysts, and has published several Austrian-friendly articles.
Economists in China are taking notice, some raising the specter of the “Hayekian risk” of wasted investment (what fellow Austrian Ludwig von Mises called “malinvestment”) over the “Keynesian risk” of inadequate demand and weak growth. As the Economist states: “Malinvestment … squanders the hard-earned saving of China’s citizens, leaving them with empty malls, rather than much-needed clinics; vacant villas alongside overcrowded dormitories; sewers that cannot cope with downpours; and buildings that collapse like tofu.”
In late 2012, a Wall Street Journal reporter interviewed Zhang Weiying, the top economist at Peking University and former government official in charge of Chinese economic policy. In the interview, Dr. Zhang invoked Hayek’s business cycle theory to warn against further Keynesian-style government spending and easy-money policies to keep the Chinese economy propped up.
“The current economy is like a drug addict, and the prescription from the doctor is morphine, so the final result will be much worse,” he said. The reporter noted, “[Zhang] invoked the ideas of the late Nobel laureate Friedrich Hayek and the Austrian School of economics to argue that if the economy weren’t allowed to adjust on its own, China’s minor bust would be followed by a bigger one.” Zhang even wrote an article lauding the libertarian Austrian economist Murray Rothbard.
Hayek’s economics have reached pop culture among economics students with the release of two rap videos: “Fear the Boom and the Bust” in 2010 and “The Fight of the Century” in 2011. Both are available on YouTube and have been seen by over 3 million viewers. Developed by director John Papola and GMU economist Russ Roberts, the lyrics pit Hayek against Keynes in the battle of ideas over how to cure depressions.
Hayek introduced his theory of the business cycle to the English-speaking world with the publication of his book Prices and Production in 1931. When Jeffrey Tucker, executive editor of Laissez Faire Books, asked me to write a new introduction to this little volume (which combines Prices and Production with the earlier Monetary Theory and the Trade Cycle), I jumped at the opportunity.
Most great works are “fat books.” Adam Smith’s Wealth of Nations, Karl Marx’s Capital, and Ludwig von Mises’ Human Action come to mind. Hayek’s Prices and Production is a thin volume of only 162 pages. Yet in its concentrated form, it brilliantly develops the key elements of the Austrian macro model and generates fruitful insights into monetary policy, the business cycle, economic growth, and finance. Sometimes, great things come out of small packages.
Hayek’s small work is relatively unknown compared to his other works, such as The Road to Serfdom (1944) and The Constitution of Liberty (1960). His Austrian-style capital and business cycle theories have come under criticism from members of the Keynesian and Chicago schools, and even occasionally from within the Austrian school. As a result, Hayek’s economics — his capital theory and his ingenious stages-of-production “triangles” — have been sadly ignored, unfairly maligned, and only recently gained respect.
Friedrich von Hayek (1890-1992) was an Austrian-born economist who earned two doctorate degrees in law and political science at the University of Vienna in the early 1920s, and then worked together with his mentor, Ludwig von Mises (1881-1973), to establish the Austrian Institute of Economic Research. Mises and Hayek were among a handful of professional economists who predicted the stock market crash in 1929 and the subsequent Great Depression of the 1930s.
More eminent academics, like the British economist John Maynard Keynes and the American Irving Fisher, failed to anticipate the collapse. The ability of Mises and Hayek to forecast the depression catapulted the Austrian school into the limelight in the early 1930s. Lionel Robbins, chairman of the economics department at the London School of Economics, invited the young Fritz Hayek to deliver a series of lectures, which were delivered in early 1931.
Prices and Productionoffered an alternative to the popular Cambridge professor J.M. Keynes (1883-1946), who favored government deficit spending to stimulate the economy and end the depression. Joseph Schumpeter claimed that Prices and Production was “met with a sweeping success that [had] never been equaled by any strictly theoretical book” — that is, before Keynes’ own General Theory swept the profession.
Hayek’s book offered a monetary explanation of the Great Depression, arguing that “monetary influences play a dominant role in determining both the volume and direction of production.” It introduced “Hayek’s triangles,” diagrams that demonstrated how all useful products go through a series of stages from earlier stages of production (raw commodities) to later stages of production (final product). For example, iron ore becomes steel, and steel becomes a hammer, where value is added with each succeeding stage.
Using the diagrams and a “time structure of production” concept, Hayek expresses the long-standing Austrian view that investment capital, once invested in specific capital goods and production processes, is inherently heterogeneous and specific in its use.
Hayek first analyzed the effects of a permanent increase in society’s saving rate. As members of society become thriftier, interest rates fall and the time dimension in Hayek’s triangle increases. As long as the national saving rate stays permanently at this higher level, macroeconomic stability can be achieved, and a nation enters a period of sustainable economic growth.
Hayek then considered the very different case of the government adopting an “easy money” policy by expanding the money supply and artificially lowering interest rates below the “natural” rate of interest. In this case, the economy suffers an inflationary boom that is not sustainable.
The effect is felt unevenly in the economy. There are winners and losers. Monetary inflation is never neutral; it affects some industries and income earners more than others. In the beginning, the boom occurs largely in the higher-order capital goods industries and commercial building sector.
Once again, the time dimension in Hayek’s triangle increases, but not permanently. Eventually, interest rates must rise, and the inflationary boom inevitably tops out and turns into a bust. Hayek’s triangle shrinks, the economy collapses into a recession, and it may take years for the industrial capital goods and building markets to recover because of their specificity and heterogeneity.
In applying his monetary theory to the Great Depression, Hayek concluded that the 1929-32 crisis occurred as an inevitable result of an unsustainable boom in the 1920s. He contended that the best cure would be to adopt a laissez faire policy — “not to use artificial stimulants… but to leave it to time to effect a permanent cure by the slow process of adapting the structure of production to the means available for capital purposes.” He and Robbins (the LSE school) strongly opposed the “elastic,” easy-money, and deficit-spending proposals of Keynes and his disciples.
The appealing contribution made by Hayek and the Austrian school is their contention that easy-money policies, artificially low interest rates, and fiscal stimulus have unintended consequences — a boom that inevitably turns into a bust.
In this sense, the Austrians are the purest of free market advocates. They are saying to the Keynesians, Marxists, and the Chicago schools that there is no free lunch in either monetary or fiscal policy. If the government embarks on these artificial means of prosperity, society will have to pay the price. This is the genius of Hayek’s Prices and Production.
Prior to the financial crisis of 2008, most economists dismissed the importance of asset bubbles having global macroeconomic effects. The Chicago school always maintained they had only secondary effects and were seldom if ever a threat to the global monetary system. But when the mortgage-derivative-securities market proved to be far larger and more global than anyone expected on Wall Street, the financial crisis of 2008 exposed the vulnerability of the monetary system.
Suddenly, the Austrian theory of structural imbalances came into vogue as one of the few macro models that explained asset bubbles. The Austrians put forth their fundamental thesis that monetary inflation is never neutral, and that asset bubbles cause unsustainable structural imbalances on a macro level. Inflation has negative unintended consequences, and they could be massive in scope. The Austrians knew that eventually a collapse was inevitable in the real-estate market. As Ludwig von Mises once said, “We have outlived the short-run and are suffering from the long-run consequences of [inflationary] policies.”
Now, finally, the Austrians were having their day in the sun.