1. Austrian Economics in Transition Harald Hagemann University of Hohenheim, Stuttgart Università degli studi di Cassino e del Lazio Meridionale March 4, 2016

2. Austrian Economics in Transition Slide 2 Course Outline 1.The Austrian School in the Interwar Period 2.Schumpeter’s theory of economic development 3.Hayek’s Austrian theory of the business-cycle March 4, 2016

3. Austrian Economics in Transition Slide 3 1. The Austrian School in the Interwar Period a)The Family Tree of Austrian Economics b)Emigration of Austrian Economists in the 1930s c)Monetary theory and business-cycle theory d)The socialist economic calculation debate e)Capital Theory / The role of time in economics f)The theory of international trade g)Game theory h)General equilibrium theory March 4, 2016

4. Austrian Economics in Transition Slide 4 March 4, 2016 1. a.) The Family Tree of Austrian Economists

5. Austrian Economics in Transition Slide 5 Nazi Germany 7 April 1933 Restoration of Civil Service Act -Dismissal of scientists for racial and/or political reasons Austria March 1938 “Anschluss” to Nazi Germany 221 out of 253 dismissed economists emigrated 51 of them had got their PhD at an Austrian University 50 from the University of Vienna 13 before 1918 37 after 1918 Two observations 1.Importance of Austrian economics (much higher share relative to population) 2.The University of Vienna had almost monopolized academic education in Austria, a situation substantially different from Germany March 4, 2016 1. b.) Emigration of Austrian Economists in the 1930s

6. Austrian Economics in Transition Slide 6 In Vienna economics in the interwar period was still taught in the law faculty. 1919-26 The three chairs in economics formerly held by Böhm-Bawerk, Wieser and Carl Grünberg became vacant. Neither of them went to Schumpeter or Mises who had the proper age and excellent publications such as Schumpeter (1911), The Theory of Economic Development Mises (1912), The Theory of Money and Credit Instead the three chairs went to  Othmar Spann, a reactionary and antisemitic supporter of the corporate state who strongly opposed the methodological individualism of the Austrian School.  Count Ferdinand Degenfeld-Schonburg, and  Hans Mayer, whose contributions on value, price and utility theory and the imputation problem did not make a lasting impact. March 4, 2016 1. b.) Emigration of Austrian Economists in the 1930s

7. Austrian Economics in Transition Slide 7 This was a clear signal for promising young economists on the low career prospects, particularly for Jews, social democrats, and liberals. Therefore many of them had left Austria long before 1938 Schumpeter1925  Bonn1932  Harvard Hayek1931  LSE1950  Chicago 1962  Freiburg Machlup1933  SUNY Buffalo1950  Johns Hopkins 1961  Princeton Haberler1934  Geneva1936  Harvard Mises1934  Geneva1940  New York Many of them had been in the U.S. before with a two-years fellowship of the Rockefeller Foundation Morgenstern 1938  Princeton since 1930 managing editor of the Zeitschrift für Nationalökonomie March 4, 2016 1. b.) Emigration of Austrian Economists in the 1930s

8. Austrian Economics in Transition Slide 8 Since Menger’s article ‘On the Origin of Money’ (EJ 1892) and his contribution on ‘Money’ to the Handwörterbuch der Staatswissenschaften monetary theory had been a major subject of Austrian economics. Ludwig von Mises’s Theory of Money and Credit may be regarded as a typical outcome of the ideas of the Austrian School. Against the background of the hyperinflationary processes in Austria and Germany after the end of World War I Mises made important revisions in the second edition of the book published in 1924. Whereas in 1912 Mises still had stressed that the primary impulse for a boom does not proceed from excessive credit creation, and located only one of several possible causes for economic fluctuations in the credit sector (see Mises, 1912: 434), he now identified banks as the main culprits responsible for an excessive credit creation by artificially lowering the rate of interest on loans below the natural rate, thereby inducing a period of unsustainable expansion. The inevitable consequence of such a credit-induced boom is a bust. March 4, 2016 1. c.) Monetary theory and business-cycle theory

9. Austrian Economics in Transition Slide 9 Mises’s argument that excessive credit by the banking sector is the decisive cause of cyclical fluctuations is most clearly stated in his Monetary Stabilization and Cyclical Policy (1928). The natural rate of interest is that rate which tends towards equilibrium on the market or, what Mises later preferred to call ‘the final state of rest’. Any prosperity brought about by the availability of easy credit according to Mises could be logically proved to be an illusory one. The ‘mania for lower interest rates’ generates a monetary policy which, sooner of later, must necessarily always lead to crisis and depression. Mises saw a remedy against the mania for lower interest rates and excesses of credit creation in the free banking alternative. There bankers would recognize soon that it is in their own interest to restrain the issue of fiduciary media. While not entirely eliminating economic fluctuations, economic crises would be much reduced. Mises (1928) thus became an early advocate of free banking as the alternative to a centralized monopolistic banking system, which some years later became the subject of investigation in the doctoral dissertation of Vera Smith The Rationale of Central Banking and the Free Banking Alternative (1936) written under the supervision of Hayek at the LSE. March 4, 2016 1. c.) Monetary theory and business-cycle theory

10. Austrian Economics in Transition Slide 10 E. Barone (1908), ‘The Ministry of Production in the Collectivist State` in F.A. Hayek (ed.) (1935), Collectivist Economic Planning: Critical Studies on the Possibility of Socialism British debate in the 1930s Hayek versus the so-called ‘neoclassical socialists’ Lange, Lerner and Dickinson German language debate in the 1920s Foundation of socialization committees in Austria and Germany after WWI Activists Otto Bauer, Rudolf Hilferding and Emil Lederer were fellow students of Schumpeter and Mises in Böhm-Bawerk’s seminar in 1905 Schumpeter was a member of the German Socialization Commission Jan.-March 1919, when he had to resign because of his appointment of Austrian Minister of Finance March 4, 2016 1. d.) The socialist economic calculation debate

11. Austrian Economics in Transition Slide 11 Key topic: question of how socialist planners might grapple with the allocation problems of a complex society It was Ludwig von Mises (1920) who in a famous paper developed the thesis that economic calculation in a socialist commonwealth is impossible because there is no price formation on free markets, and therewith launched the socialist calculation debate in the German language area in the 1920s, which found its sequel in Britain in the 1930s. It should be pointed out, that Mises only fully developed his essential argument that the economy is in a process of permanent change and that therefore the data necessary for efficient planning are not available, only in the second 1932 edition of his book on socialism (Gemeinwirtschaft 1922), in which he sharpened his thesis not least because of the critique which had been raised against his views by Jacob Marschak, Karl Polányi and others. All the more so this holds for Hayek’s important writings since 1935 in which he developed the argument on the dispersion of knowledge and the problem of decision-making with uncertainty and incomplete information. March 4, 2016 1. d.) The socialist economic calculation debate

12. Austrian Economics in Transition Slide 12 According to Machlup (1982) the essential components of Austrian economics consist of (1)methodological individualism (2)methodological subjectivism (3)tastes and preferences (4)the concept of opportunity costs (5)marginalism and the (6)time structure of production. From the perspective of late twentieth-century Austrian economics Kirzner (1994, I: XIX) criticizes Machlup for the absence of emphasis on markets and competition as processes of learning and discovering in an environment of Knightian uncertainty. Kirzner, I. M. (ed.) (1994), Classics in Austrian Economics. A Sampling in the History of a Tradition, 3 vols., London: Pickering & Chatto. March 4, 2016 1. e.) Capital Theory / The role of time in economics

13. Austrian Economics in Transition Slide 13 The time structure of production is particularly relevant for questions of capital theory which in its Austrian form had been mainly shaped by Böhm- Bawerk. The Austrian theory of capital and Böhm-Bawerk’s concept of the average period of production played a significant role in the famous ‘triangle chapter’ of Hayek’s Prices and Production. However, the 1930s were characterised by a capital controversy which was as fierce as the later Cambridge-Cambridge controversy in the 1960s. A key axis of the capital debate in the 1930s was the Hayek-Knight controversy. It was Oskar Morgenstern in particular who gave contributions on capital theory and the role of time in economics, to which his friend Paul Rosenstein-Rodan (1930) had already made an important contribution in the very first issue, prominent space in the Zeitschrift für Nationalökonomie. March 4, 2016 1. e.) Capital Theory / The role of time in economics

14. Austrian Economics in Transition Slide 14 Morgenstern (1935) himself also published an important paper in which he contributed to the critique of the average period of production a concept which Hayek finally gave up in his Pure Theory of Capital (1941), a project into which Hayek had embarked in 1934 to defend the core of Austrian capital theory against Knight and other critics. His adoption of the notion of a multidimensional heterogeneous capital structure left the readers puzzled over the remains of an Austrian theory of capital. March 4, 2016 1. e.) Capital Theory / The role of time in economics

15. Austrian Economics in Transition Slide 15 Haberler’s work in international economics in the interwar period has been often and rightly celebrated for brilliant theoretical innovations (Baldwin QJE 1982, Samuelson, Obituary, EJ 1996). Undoubtedly, his most important theoretical contribution was the reformulation of Ricardo’s theory of comparative costs in his article ‘The Theory of Comparative Costs and its Use in the Defence of Free Trade’ (Haberler 1930), in which he introduced the ‘production substitution curve’, today’s production-possibility frontier or transformation curve, allowing for several factors of production. Haberler’s contribution revolutionised the theory of international trade and paved the way for the subsequent work of Ohlin, Samuelson and others. March 4, 2016 1. f.) The theory of international trade

16. Austrian Economics in Transition Slide 16 In his later textbook The Theory of International Trade (1933) Haberler made full use of his new concepts and, moreover, integrated real and monetary aspects of international economics, also employing supply and demand functions in the analysis of currency markets. He also integrated international aspects into his theory of economic fluctuations. In this respect the chapter on the international aspects of business cycles in Prosperity and Depression has to be regarded as a highly innovative contribution. Haberler’s discussion of how the degree of capital mobility and the exchange rate system influence the international transmission of business cycles is particularly noteworthy. March 4, 2016 1. f.) The theory of international trade

17. Austrian Economics in Transition Slide 17 von Neumann, John, Morgenstern, Oskar, Theory of Games and Economic Behaviour, Princeton UP 1944. The cooperation between the two authors was only realized at the Institute for Advanced Study in 1939-43. The roots of game theory can be traced back to Morgenstern’s Vienna habilitation thesis on economic forecasting (1928), which had been written while Morgenstern was a Rockefeller Foundation Fellow in the USA 1926–27, and to his 1935 article on ‘Perfect Foresight and Economic Equilibrium’. In these writings Morgenstern emphasized the incompatibility of perfect foresight and economic equilibrium. Morgenstern had early on recognized that in the great majority of human actions the decision maker faces one or more other decision makers who can either cooperate with him or compete or confront him. John von Neumann (1928) Zur Theorie der Gesellschaftsspiele. March 4, 2016 1. g.) Game theory

18. Austrian Economics in Transition Slide 18 March 4, 2016 1. g.) Game theory

19. Austrian Economics in Transition Slide 19 Mathematical Colloquium Karl Schlesinger gave a seminar ‘On the Production Equations of Economic Value Theory’ in March 1934, in which he discussed the question of a general, positive and unique solution of a general equilibrium system. He stimulated Abraham Wald to give the first consistent proof for the existence of a general equilibrium for a stationary economy a year later. It was then John von Neumann who in 1936 in Menger’s Vienna Colloquium expanded the proof for the general case of a growing economy. Considering most Austrian economists’ neglect, often hostility towards mathematical methods, it is not without a certain irony that the two areas of game theory and general equilibrium theory are highly mathematical and that Carl Menger’s son Karl played a major role in the latter field. March 4, 2016 1. h.) General equilibrium theory

20. Austrian Economics in Transition Slide 20 Conclusion Austrian economics in the interwar period was certainly wrestling with capital and time, equilibrium and business cycles as well as the possibilities and limitations of economic socialism. The preceding short survey of important contributions of Austrian economics in the interwar period has shown that Boehm (1992: 1) was right in his assessment that ‘interwar Austrian economic thought is a venture of many dimensions that does not easily lend itself to a reduction to some invariable standard. The label “Austrian economics” is merely a shorthand expression for what is, in fact, an ill-defined body of ideas with many facets’. Boehm also pointed out ‘that in the 1930s Austrian economics […] suffered from a series of blows it proved rather difficult to recover from […], notably in the Hayek–Sraffa exchange, the capital controversies, and the debates with the Keynesians’ (ibid: 3), an assessment which is heavily strengthened by Mark Blaug in his commentary. March 4, 2016 1. The Austrian School in the Interwar Period

21. Austrian Economics in Transition Slide 21 2. Schumpeter’s theory of economic development a)From ‘crisis theory’ to ‘business-cycle theory’ b)Schumpeter’s ‘Triad’: Innovations, pioneering entrepreneurs and bank credit c)The ‘Schumpeter-Hahn cycle’ versus the ‘Mises-Hayek cycle’ d)Business cycles and growth cycles: Schumpeter’s fascination by Kondratieff’s ‘long waves’ e)The ‘lost seventh chapter’: Schumpeter and the German Historical School March 4, 2016

22. Austrian Economics in Transition Slide 22 Joseph A. Schumpeter (1883 - 1950) 1908: Habilitation in Vienna Das Wesen und der Hauptinhalt der theoretischen Nationalökonomie 1909: a.o. Professor Czernowitz 1911: Professor Graz 1912: Theorie der wirtschaftlichen Entwicklung (1934 Theory of Economic Development) 1919: Austrian Finance Minister 1921: President Biedermann Bank 1925: Professor, University of Bonn 1932: Harvard University 1939: Business Cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process (German 1961) 1942: Capitalism, Socialism and Democracy 1954: History of Economic Analysis 2. Schumpeter‘s theory of economic development March 4, 2016 2. Schumpeter‘s theory of economic development

23. Austrian Economics in Transition Slide 23 In the Preface to the first German edition of The Theory of Economic Development Schumpeter (1911, p. VIII) points out that he had started his analysis with the concrete theoretical issues involved in the crisis problem in 1905. Furthermore, he makes clear that this book and his earlier one on Das Wesen und der Hauptinhalt der theoretischen Nationalökonomie (The Nature and the Main Content of Theoretical Economics) (Schumpeter 1908) form an entity, although the second one can be read independently of the first one. The division of labour between the two books can be understood best with regard to the two masters Walras, Schumpeter's great hero, and Marx, whose views on the long-run development of the capitalist economy form a life-long challenge for Schumpeter. March 4, 2016 2. a.) From ‘crisis-theory’ to ‘business-cycle theory’

24. Austrian Economics in Transition Slide 24 In the Preface to the Japanese edition he emphasizes that Walras provided us with a theory which embraces “the pure logic of the interdependence between economic quantities”, whereas Marx's genuine contribution to economics is “a vision of economic evolution as a distinct process generated by the economic system itself” (Schumpeter 1937, pp. 165-6). This corresponds to the distinction between static and dynamic analysis, which plays a major role in his work. Due to the influence of Frisch in contrast to the 1926 German edition in the 1934 English edition the terms “statics” and “dynamics” are fully replaced by the concepts of the “circular flow” and “economic development”. March 4, 2016 2. a.) From ‘crisis-theory’ to ‘business-cycle theory’

25. Austrian Economics in Transition Slide 25 Accordingly, Schumpeter’s economic dynamics deals with the changing of the data of the static system, or the destruction of the circular flow by the carrying out of new combinations that includes the five cases of the introduction of new methods of production, new products, the opening of new markets, new sources of supply, and new forms of organization. In Schumpeter’s system economic dynamics is strongly linked to the phenomenon of economic development. The main carrier of economic development is the pioneering entrepreneur, who is an endogenous force in the economy and in marked contrast to the great majority of people limited to taking routine actions only. 2. Schumpeter‘s theory of economic development March 4, 2016 2. b.) Schumpeter‘s ‘Triad’

26. Austrian Economics in Transition Slide 26 In Schumpeter’s view not only the final chapter 6 but in fact any single page of his Theory of Economic Development is dedicated to the problem of the business cycle, and analyzing business cycles “means neither more nor less than analyzing the economic process of the capitalist era” (Schumpeter 1939, p. V). Economic Development in the sense of Schumpeter is endogenous, spontaneous and discontinuous. It is the task of dynamic theory to explain the origin and effects of these transition processes which essentially are a disturbance of equilibrium. March 4, 2016 2. b.) Schumpeter‘s ‘Triad’

27. Austrian Economics in Transition Slide 27 The importance of innovations and credit is at the very center of Schumpeter’s Theory of Economic Develop- ment. As Streissler has emphasized, it were not the figure of the pioneering entrepreneur and the importance of bank credit for economic development that were new in Schumpeter but rather the idea of creative destruction by innovations and the notion that bank credit was the prerequisite of innovations and of the foundation of new enterprises. Credit and Innovations in Schumpeter’s BCT (1) March 4, 2016 2. b.) Schumpeter‘s ‘Triad’

28. Austrian Economics in Transition Slide 28 The innovating entrepreneurs need financial means for their investment activity which is given to them in form of credit by the banking system. Schumpeter shares Wicksell’s view that the disturbance of economic equilibrium primarily emerges because of an enlargement of profitable investment options, leading to an increase of the natural rate of interest in Wicksell’s Interest and Prices (1898), rather than by a lowering of the money rate of interest below the level of the natural rate by the banks, thereby causing a period of expansion which is unsustainable. Credit and Innovations in Schumpeter’s BCT (2) March 4, 2016 2. b.) Schumpeter‘s ‘Triad’

29. Austrian Economics in Transition Slide 29 Credit and Innovations in Schumpeter’s BCT (3) The latter is emphasized in the works of his two compatriots Hayek’s Prices and Production and Mises’s Theory of Money and Credit. There, the bust is the inevitable consequence of the credit-induced boom in which the reallocation to excessively roundabout methods of production is corrected. Mises’s argument of excessive credits by the banking sector as the decisive cause of cyclical fluctuations is most clearly stated in his Monetary Stabilization and Cyclical Policy (1928), in which he not only distances himself from views still held by Schumpeter but even from his own earlier views. March 4, 2016 2. b.) Schumpeter‘s ‘Triad’

30. Austrian Economics in Transition Slide 30 Credit and Innovations in Schumpeter’s BCT (4) Schumpeter’s assumption that available resources are fully utilized in the stationary circular flow implies that the carrying out of new combinations requires a different employment or reallocation of these resources. The entrepreneur must resort to credit if she wishes to carry out new combinations since they cannot be financed by the returns from established production activities. Schumpeter also considers “saving” as a result of previous development. The financing of innovations by means of credit is the function of the banking system. In Schumpeter’s view the banker is not the trader but the producer of purchasing power. “[C]redit is essentially the creation of purchasing power for the purpose of transferring it to the entrepreneur, but not simply the transfer of existing purchasing power” (Schumpeter 1934, p. 107). March 4, 2016 2. b.) Schumpeter‘s ‘Triad’

31. Austrian Economics in Transition Slide 31 Credit and Innovations in Schumpeter’s BCT (5) The consequence of the creation of new purchasing power “out of nothing”, i.e. not rooted in previous savings, is an increase of aggregate demand in monetary terms, which leads to an increase in prices. The credit-induced inflation acts as a tax on the mere managers stiffened in routine actions thereby implying a reallocation of productive resources. Although interest on capital is a monetary phenomenon, it is ultimately based on a real factor: the productivity-enhancing effects of innovations. Schumpeter thus makes forced savings, which play an important role in the analyses of his contemporaries Wicksell, Mises, Hayek and Robertson (“imposed lacking”) but were already an argument in Henry Thornton as early as 1803, an integral part of his theory. March 4, 2016 2. b.) Schumpeter‘s ‘Triad’

32. Austrian Economics in Transition Slide 32 Credit and Innovations in Schumpeter’s BCT (6) However, in contrast to Mises and Hayek who were adherents of the orthodox doctrine that only voluntary savings can create sustainable capital and held the view that the granting of a volume of credit which transcends the level of voluntary savings by the banking system inevitably leads to a crisis, the creation of money and credit for Schumpeter is an essential condition for the financing of innovational activities and thus development in competitive capitalism. Moreover, “the credit system is no very active factor in the mechanism of cycles. It adapts itself to the demand which comes from entrepreneurs and submits to contraction by their repayment of loans. In both cases its role is rather a passive one” (Schumpeter 1931, p. 17).  idea of endogeneity March 4, 2016 2. b.) Schumpeter‘s ‘Triad’

33. Austrian Economics in Transition Slide 33 Schumpeter opposed the idea that the succession of prosperity and depression is a purely monetary phenomenon. Three factors are considered: 1. The competition for the scarce means of production causing price increases of investment goods in the boom. 2. The decline in prices when the new products enter the markets as the consequence of the enlarged productive capacities, thereby making a depression unavoidable. 3. Then the entrepreneurs use their returns for paying back their debts causing a credit deflation just in that period when the additional goods which could take away inflationary pressure as a consequence of the “abnormal” credit inducing the boom could be produced in a regular manner. Credit and Innovations in Schumpeter’s BCT (7) March 4, 2016 2. b.) Schumpeter‘s ‘Triad’

34. Austrian Economics in Transition Slide 34 Credit and Innovations in Schumpeter’s BCT (8) Schumpeter’s views found the most innovative resonance in the contemporary German literature in Lucien (L.) Albert Hahn’s Volkswirtschaftliche Theorie des Bankkredits (Economic Theory of Bank Credit) (1920), a fact which is explicitly emphasized by Schumpeter in the second edition of TED when he refers the reader to Hahn’s “original and meritorious book, which has essentially advanced our knowledge of the problem” at the beginning of his discussion of the nature and function of credit (Schumpeter 1934, p. 95, fn. 1). March 4, 2016 2. b.) Schumpeter‘s ‘Triad’

35. Austrian Economics in Transition Slide 35 L. Albert Hahn’s Economic Theory of Bank Credit Hahn emphasizes, as later Keynes, the deflationary effects of voluntary savings and the positive effects of an expansionary credit policy for innovations and employment. A key statement reads: “Capital formation is not the result of saving but of credit.” (Hahn 1920, p.120) Hahn takes up Schumpeter’s distinction between “normal” and “abnormal” credit and elaborates the distinction between “non-inflationary” credit (in the amount of overall savings) and inflationary credit due to the money-creating ability of the banking sector. March 4, 2016 2. c.) The ‘Schumpeter-Hahn cycle’ versus the ‘Mises-Hayek cycle’

36. Austrian Economics in Transition Slide 36 Schumpeter vs. Hahn (1) However, Schumpeter (1926) in the 2nd German edition of TED, feels obliged to keep some distance from Hahn, whose much stronger emphasis on the directly production-enhancing effects of an inflationary credit creation caused his accusation as an “inflationist”, when he points out: “Against his formulation it appears to me correct to say: although not by existing goods, the quantity of new purchasing power that it is possible to create is supported and limited by future goods.” (p. 165) March 4, 2016 2. c.) The ‘Schumpeter-Hahn cycle’ versus the ‘Mises-Hayek cycle’

37. Austrian Economics in Transition Slide 37 Schumpeter vs. Hahn (2) It is clear that for Schumpeter the spending of credit for innovative investments is decisive, not for increased consumption. This becomes particularly evident in his statements on capital which is regarded as a fund of purchasing power. “Capital is nothing but the lever by which the entrepreneur subjects to his control the concrete goods which he needs, nothing but a means of directing the factors of production to new uses, or of dictating a new direction for production.” (TED 1934, p.116). March 4, 2016 2. c.) The ‘Schumpeter-Hahn cycle’ versus the ‘Mises-Hayek cycle’

38. Austrian Economics in Transition Slide 38 The Business Cycle as a Superposition of Different Waves (1) In his Business Cycles, Schumpeter (1939) distinguishes four phases of economic fluctuations: prosperity, recession, depression and recovery, and presents a three-cycle schema, in which Kondratieff long-waves constitute the framework where they are combined with the classical Juglar and the shorter Kitchin cycles. In the preface to the English edition of TED we find the following statement: ”I took it for granted that there was a single wave-like movement, viz. that discovered by Juglar. I am convinced now that there are at least three such movements, probably more, and that the most important problem which at present faces theorists of the cycle consists precisely in isolating them and in describing the phenomena incident to their interaction. But this element has not been introduced into the later editions” (1934, p. IX). March 4, 2016 2. d.) Business cycles and growth cycles

39. Austrian Economics in Transition Slide 39 The Business Cycle as a Superposition of Different Waves (2) This statement is not surprising because the Kitchin and the Kondratieff cycle were born in the economic literature only in the 1920s. Schumpeter himself was the co-editor of the journal in which Kondratieff’s famous article on “The long waves in economic life” was published in German in 1926. However, it is quite interesting to notice that the idea of superposition of different complexes of causality was already there when Schumpeter presented the main ideas on the wave-like fluctuation in economic activity to the Harvard faculty shortly before the outbreak of World War I. March 4, 2016 2. d.) Business cycles and growth cycles

40. Austrian Economics in Transition Slide 40 Source: Schumpeter (1939), p. 213 Schumpeter’s basic idea that cyclical fluctuations consist of many waves: a composite of three cycles of different length. Kondratieff (1)-, Juglar (2)- and Kitchin (3)-Cycles The Business Cycle as a Superposition of Different Waves (3) March 4, 2016 2. d.) Business cycles and growth cycles

41. Austrian Economics in Transition Slide 41 Business Cycles –Kitchin cycleLength: 3-5 years Inventory investment –Juglar cycleLength: 7-11 years Machinery equipment Growth Cycles –Kuznets cycleLength: 15-25 years Investment in buildings –Kondratieff cycleLength: 45-60 years Basic capital innovations March 4, 2016 2. d.) Business cycles and growth cycles

42. Austrian Economics in Transition Slide 42 The jerky character of economic evolution can hardly be denied and it is one of Schumpeter’s great merits to emphasize the importance of integrating the study of business cycles with an analysis of long-run economic development which does not follow a steady-state or balanced growth path. Innovations are not only the decisive impulse of cyclical fluctuations but the period of their implementation also determines the different length of the cycles. With some qualification with regard to the Kitchin the simultaneous presence of cycles of different order for Schumpeter “is a problem of interference only and not … a problem of different causation.“ March 4, 2016 2. d.) Business cycles and growth cycles

43. Austrian Economics in Transition Slide 43 Schumpeter’s monocausality argument also is at odds with the later understanding of economic theory that the cycles of different duration are related to different types of investment goods as the causal factor, i.e. that we have to distinguish between fluctuations in inventories (Kitchin), fluctuations in fixed capital investment (Juglar or Marx’s echo effect), fluctuations in construction investment (Kuznets) and fluctuations in basic capital goods as the medium for basic innovations (Kondratieff). Although Schumpeter was willing to consider and integrate the most recent and important developments in economic theory, he clearly did not want to change his early vision laid down in his theory of economic development. March 4, 2016 2. d.) Business cycles and growth cycles

44. Austrian Economics in Transition Slide 44 NameKitchin cycleJuglar cycleKuznets cycle Kondratieff cycle Type Business Cycle Growth Cycle Long Waves Length 3-5 years7-11 years15-25 years45-60 years Causal Factor Fluctuations in inventories Fluctuations in fixed capital investments Fluctuations in construction investments Fluctuations in basic innovations and/or basic capital goods March 4, 2016 2. d.) Business cycles and growth cycles

45. Austrian Economics in Transition Slide 45 Long Waves of Economic Cycles (1) March 4, 2016 2. e.) The ‘lost seventh chapter’: Schumpeter and the German Historical School

46. Austrian Economics in Transition Slide 46 Long Waves of Economic Cycles (2) In the “lost seventh chapter” of the first German edition of The Theory of Economic Development (Schumpeter 1911) ‘Das Gesamtbild der Volkswirtschaft’ (The Overall View of the Economy), Schumpeter had analysed already the theoretical and historical development problem and emphasized the importance of statistical analysis. He recognized that economic development is essentially discontinuous since innovations arise unevenly over the various industries. Entrepreneurs are followed by many imitators so that innovations tend to cluster. March 4, 2016 2. e.) The ‘lost seventh chapter’: Schumpeter and the German Historical School

47. Austrian Economics in Transition Slide 47 3. Hayek’s Austrian theory of the business-cycle a)Equilibrium and the business cycle: The methodological challenge by Adolph Lowe b)Wicksell’s distinction between the market rate and the natural (equilibrium) rate of interest c)Monetary overinvestment: Mises’s theory of money and credit d)The time structure of the production process: Triangles and Böhm-Bawerk’s theory of capital e)Cantillon effects f)Ricardo effects March 4, 2016

48. Austrian Economics in Transition Slide 48 1927 – 1931: Founding Director of the Austrian Institute for Business-Cycle Research in Vienna (today‘s WIFO) 1928: Habilitation in Vienna 1929: Geldtheorie und Konjunkturtheorie (Monetary Theory and the Trade Cycle, 1933) 1931: Prices and Production London School of Economics (Tooke Professor of Political Economy) 1941: The Pure Theory of Capital 1950: Chicago 1961: Freiburg 1974: Nobel prize together with Gunnar Myrdal Friedrich August Hayek (1899-1992) March 4, 2016 3. Hayek‘s Austrian theory of the business-cycles

49. Austrian Economics in Transition Slide 49 Hayek’s Business-cycle theory is a combination of five building blocks (Prices and Production, 1931) (1)Wicksell’s theory of the cumulative process where price changes are caused by the discrepancy between the market rate and the natural (equilibrium) rate of interest; (2)Mises’s theory of money and credit in which banks artificially lowering the money (market) rate of interest are responsible for overinvestment and a misallocation of resources which necessarily has to be corrected. (3)Böhm-Bawerk’s theory of capital with its emphasis on the time structure of the production process; (4)Cantillon effects of changes in the money supply on the price structure and hence on the structure of production (non-neutrality of money); (5)Ricardo effects of a shortage of consumption goods on the production of investment goods (disproportionality of circulating and fixed capital). March 4, 2016 3. Hayek‘s Austrian theory of the business-cycles

50. Austrian Economics in Transition Slide 50 Equilibrium and the Business Cycle (1) Lowe’s methodological challenge: – The abandonment of static equilibrium theory by Lowe and, among others, endorsed by Kuznets. – the defence of the equilibrium method by dichotomizing the cycle from the trend and by introducing money and credit as a propagation mechanism for cyclical fluctuations in an existing equilibrium configuration, as it was the case in Hayek's response to Lowe's challenge. – a path-dependent approach without an a priori trend line, as it had been developed by Schumpeter. – the defence of the prevailing equilibrium approach by denying the need for the development of a general theory of the business cycle since the business cycle does not exist and the real problem of analysing concrete-historical cases of fluctuations with a variety of different factors at work, could be completely dealt with within the framework of a modern static equilibrium approach (Lutz 1932). March 4, 2016 3. a.) The methodological challenge by Adolf Lowe

51. Austrian Economics in Transition Slide 51 Equilibrium and the Business Cycle (2) Lowe: how is business cycle theory possible at all? “The business cycle problem is not a reproach for, but a reproach against the static system, because in it it is an antinomic problem. It is solvable only in a system in which the polarity between upswing and crisis arises analytically from the conditions of the system just as undisturbed adjustment derives from the conditions of the static system. Those who wish to solve the business-cycle problem must sacrifice the static system. Those who adhere to the static system must abandon the business-cycle problem.” (Lowe [1926] 1997: 267) Kuznets regarded “the equilibrium approach … to be a blind alley from the point of view of business-cycle theory” (QJE, 1930: 399) “… the practice of treating change as a deviation from an imaginary picture of a rigid equilibrium system must be abandoned” (ibid.:415) March 4, 2016 3. a.) The methodological challenge by Adolf Lowe

52. Austrian Economics in Transition Slide 52 Equilibrium and the Business Cycle (3) Hayek: The logic of equilibrium theory “properly followed through, can do no more than demonstrate that such disturbances of equilibrium can only come from outside - i.e. that they represent a change in the economic data - and that the economic system always reacts to such changes by its well-known methods of adaptation, i.e. by the formation of a new equilibrium.” (Hayek 1933: 42-43) The incorporation of cyclical phenomena into equilibrium theory is the crucial problem of business-cycle theory and that, accordingly, cycles should be explained as endogenous outcomes of market processes. Money and credit as a decisive endogenous propagation mechanism for business cycles. “Yet the concept of equilibrium is just as indispensable a tool for the analysis of temporal differences in prices as it is for any other investigation in economic theory. Strictly speaking, its field of application is identical with that of economic theory, since only with its assistance is it possible to give a summary depiction of the very great number of different tendencies of movement which are operative in every economic system at every point in time.” (Hayek [1928] 1984: 75; emphasis added) March 4, 2016 3. a.) The methodological challenge by Adolf Lowe

53. Austrian Economics in Transition Slide 53 Hayek agrees with Lowe -that the integration of business-cycle phenomena into the system of the theory of economic equilibrium is the decisive problem of business-cycle theory, -in the claim for an explanation of business cycles by an endogenous theory, -in his emphasis on the importance of production structures. Hayek differs from Lowe -in his adherence to general equilibrium theory also in the explanation of business cycles (  Lucas and modern equilibrium business-cycle theory, EBC), -in identifying money and credit instead of technical progress as the decisive endogenous factor, -in using a vertical instead of a horizontal production structure. Hayek – Lowe debate (1926 - 33) March 4, 2016 3. a.) The methodological challenge by Adolf Lowe

54. Austrian Economics in Transition Slide 54 “Old” roots for the Lucas project? Lucas “Understanding Business Cycles” 1977: 7 “(…) the incorporation of cyclical phenomenon into the system of economic equilibrium theory, with which they are in apparent contradiction, remains the crucial problem of Trade Cycle Theory” (Hayek [1933]: 33n.) “By “equilibrium theory” we here primarily understand the modern theory of the general interdependence of all economic quantities, which has been most perfectly expressed by the Lausanne School of theoretical economics” (Hayek [1933]: 42n.) March 4, 2016 3. a.) The methodological challenge by Adolf Lowe

55. Austrian Economics in Transition Slide 55 Wicksell’s theory of the cumulative process (1) It was Wicksell's main achievement to have elaborated an analysis in which time and money are subjected to the marginal principle. The market rate of interest serves the double function of coordinating the supply and demand for all loanable funds and at the same time the supply and demand for real capital in terms of saving and investment. An increase (decrease) in savings due to a change in individuals’ intertemporal preferences would lead to a lower (higher) rate of interest and a lengthening (shortening) or more (less) roundabout method of production. The natural rate of interest acts as the centre of gravitation for the market rate of interest which in monetary equilibrium also equals the marginal physical productivity of real capital. March 4, 2016 3. b.) Wicksell‘s distinction between the market rate and the natural rate of interest

56. Austrian Economics in Transition Slide 56 Wicksell’s theory of the cumulative process (2) Wicksell’s ideas on the dis- and reequilibrating mechanism of divergences between the money and the natural rate of interest provided an important building block for Austrian business-cycle theory as it was developed by Mises and particularly Hayek, who combined Wicksell’s analysis of the cumulative processes with the doctrine of “forced saving” (see “A Note on the development of the doctrine of ‘forced saving’” (1932); reprinted as chapter VII in Hayek 1939) to generate a monetary theory of the business cycle in which injections of money or bank credit lead to overinvestment and thereby to a distortion in the time structure of production which is unsustainable. In principle two major impulses which can cause a divergence between the two rates of interest have to be distinguished: March 4, 2016 3. b.) Wicksell‘s distinction between the market rate and the natural rate of interest

57. Austrian Economics in Transition Slide 57 Wicksell’s theory of the cumulative process (3) 1.an improvement in profit expectations due to technical progress which causes an increase in the natural rate of interest and investment demand; 2.a generous granting of credit by the banking system which leads to a fall of the money rate of interest below the natural rate. Whereas the first impulse is real and a “natural” one, the second impulse is a monetary one and, in the view of Mises and Hayek, “artificial”. Although Wicksell mainly elaborated his cumulative process analysis for a better understanding of changes in the general level of prices and his business-cycle theory remained a fragment or an “enigma” (Wicksell [1907] 1951), we have to note that “Wicksell was, in short, so impressed by the real elements in cyclical fluctuations, and in particular those involving investments activity that he treated monetary aspects of the cycle as peripheral.” Laidler (1991: 146) March 4, 2016 3. b.) Wicksell‘s distinction between the market rate and the natural rate of interest

58. Austrian Economics in Transition Slide 58 Wicksell’s theory of the cumulative process (4) Thus Wicksell emphasizes technology shocks and perceives in real factors which lead to an increase in the natural rate of interest the essential reason for business cycles. With the emphasis on technical progress Wicksell stood in the German tradition of such diverse authors as Marx and Schumpeter. In the contemporary debate with Hayek and Mises this argument was made by Löwe and Burchardt who, with explicit reference to Wicksell, pointed out that, although changes in the market rate of interest are important for movements of the price level, the real impulse for the disturbance of equilibrium is given by technical progress which increases the natural rate. March 4, 2016 3. b.) Wicksell‘s distinction between the market rate and the natural rate of interest

59. Austrian Economics in Transition Slide 59 Ludwig von Mises had established himself as the first leading representative of a monetary theory or credit view of the business cycle in the German language area with the publication of his The Theory of Money and Credit (1912). Mises can be recognized as the pioneer of a typically “Austrian” theory of the business cycle. It is a central element of his “circulation credit theory” that the banking system grants a volume of credit which transcends the level of voluntary savings, thereby causing a misallocation of resources. The boom thus contains the seed of its later correction. March 4, 2016 3. c.) Monetary overinvestment: Mises‘s theory of money and credit

60. Austrian Economics in Transition Slide 60 Mises took over the theorem of the two interest rates from Wicksell. However, he criticised the latter for concentrating too narrowly on the effects of this divergence on the absolute level of prices, thereby overlooking the impact of additional credit for the structure of production. The expansion of credit and the lowering of the money rate of interest below the natural rate creates an artificial or “unhealthy boom” (Mises [1936] 1983: 4) in which entrepreneurs are forced to enter upon longer processes of production. However, despite the initial increase in productive activities the consequences finally are negative ones because the gratuitous nature of credit contains the seeds of its own destruction. March 4, 2016 3. c.) Monetary overinvestment: Mises‘s theory of money and credit

61. Austrian Economics in Transition Slide 61 “But there cannot be the slightest doubt as to where this will lead. A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods. This time must come all the more quickly inasmuch as the fall in the rate of interest weakens the motive for saving and so slows up the rate of accumulation of capital.” (Mises [1924] 1981: 401) Thus the excess investment generated by credit creation and the artificial lowering of the money rate of interest below the natural rate is stopped by a shortage of savings before the lengthening of the production processes are coming to fruition. A further injection of credit could prolong the process but would make things even worse since inflation would accelerate and the corrective crisis aggravate. March 4, 2016 3. c.) Monetary overinvestment: Mises‘s theory of money and credit

62. Austrian Economics in Transition Slide 62 Hayek from the beginning followed Mises’s view that discrepancies between the money and the natural rates of interest cause discrepancies in the structure of production, i.e. a deviation of the allocation of productive resources to capital goods and consumptions goods which differs from the allocation in equilibrium. He criticizes Wicksell for focussing on changes in the purchasing power of money in his cumulative process analysis, as well as Löwe and Burchardt for only identifying general price changes as monetary effects. According to Hayek “monetary theory has by no means finished its work when it has explained the absolute level of prices.” March 4, 2016 3. c.) Monetary overinvestment: Mises‘s theory of money and credit

63. Austrian Economics in Transition Slide 63 Furthermore, “general price changes are no essential feature of a monetary theory of the Trade Cycle; they are not only unessential, but they would be completely irrelevant if only they were completely 'general' – that is, if they affected all prices at the same time and in the same proportion” (Hayek [1929] 1933: 117 n. and 123). Consequentially, a stabilization of the price level would not eliminate cyclical fluctuations. Wicksell had introduced the important distinction between the stability of the equilibrium of relative prices and the (in)stability of monetary (general price level) equilibrium. In contrast to Wicksell’s monetary equilibrium and old and new monetarist views of the “neutrality” of money Hayek's monetary equilibrium was not associated with the price level but with the system of relative prices. March 4, 2016 3. c.) Monetary overinvestment: Mises‘s theory of money and credit

64. Austrian Economics in Transition Slide 64 Böhm-Bawerk’s theory of capital (1) March 4, 2016 3. d.) The time structure of the production process

65. Austrian Economics in Transition Slide 65 Böhm-Bawerk’s theory of capital (2) March 4, 2016 3. d.) The time structure of the production process

66. Austrian Economics in Transition Slide 66 Böhm-Bawerk’s theory of capital (3) March 4, 2016 3. d.) The time structure of the production process

67. Austrian Economics in Transition Slide 67 Initially, the economy is in equilibrium. This implies full employment and a market rate of interest that equates investment demand with voluntary saving, as determined by intertemporal consumer preferences. Money is neutral in the sense that it leaves ‘the relative values of goods... undisturbed’ (Hayek 1935: 31). The disturbance which causes cyclical fluctuations is a difference between the market rate of interest and the equilibrium rate, to the extent that the lending rates of the banks are lower than the equilibrium rate. This is perceived as a signal for a profitable lengthening of production processes. Credit demand will rise and additional money will be injected into the economy by a lengthening of the banks’ balance sheets. March 4, 2016 3. e.) Cantillon effects

68. Austrian Economics in Transition Slide 68 Under the assumption that all resources are fully utilized in equilibrium, a credit expansion implies that producers of capital goods in the ‘new’ processes of production bid away resources from ‘older’ processes. This is where the Cantillon effect begins to work. The injection of additional money increases the purchasing power in those parts of the economy where the money arrives first. The bidding changes the price structure, reallocates resources and redistributes incomes (Hayek 1935: 8f and 85ff). Inflation in the Hayekian sense is thus strictly defined as a rise in the quantity of money, not in the price level. Inflation is not uniquely reflected in movements of the price level, and the monetary cause of changes in the price structure will hardly be perceived as such. March 4, 2016 3. e.) Cantillon effects

69. Austrian Economics in Transition Slide 69 Forced saving Meanwhile, the redirection of capital towards ‘new’, longer processes of industrial production reinforces itself since the prices of capital goods rise faster than the prices of consumer goods. This leads to a squeeze of the price margins between the stages of production and a corresponding fall in the rates of return on capital in the ‘older’, shorter processes. The output of consumption goods declines, even though consumer preferences remain unchanged and money incomes have risen with labour demand in the production of capital goods. Shortages of consumption goods make their prices rise faster than incomes. This process constitutes the mechanism of ‘forced saving’ which, in Hayek's view, will eventually make the redirection of resources into less roundabout production profitable. Yet the boom prevails as long as the credit expansion favours investment in more roundabout processes. March 4, 2016 3. e.) Cantillon effects

70. Austrian Economics in Transition Slide 70 At some point, the credit expansion must stop. Normally the downturn is brought about by a rise in the lending rates which makes the completion of the ‘new’, more roundabout projects unprofitable. However, according to Hayek it is sufficient that inflation stops to accelerate. Firms in the capital goods sector will then lose their lead in purchasing power, whereas the given demand continues to raise the prices of consumption goods. This increases the price margins and reinforces a fall in real wages whereby shorter, more labour-intensive processes of production regain their profitability. The Cantillon effect ceases to be effective, whereas the Ricardo effect now makes itself felt in a cumulative decrease of the roundaboutness of production. The structure of production that is produced by inflation turns out to be unsustainable because of a disproportionality of fixed and circulating capital, respectively capital and consumption goods (1935: 9lff). The specific resources employed in the ‘unduly elongated’ processes of production (both capital and qualified labour) become redundant. Even unspecific resources may not be integrated into the remaining profitable processes without frictions. March 4, 2016 3. e.) Ricardo effects

71. Austrian Economics in Transition Slide 71 Summary: the crisis as a cure The credit boom is thus inevitably followed by unemployment and capital destruction. The changes to more productive methods of production turn out to be futile, unless the credit expansion is accidentally succeeded by an increase in voluntary saving (Hayek 1939: 180). Even though Hayek did not write much about the crisis (not to mention the lower turning point), he essentially regarded the crisis as a cure that has to be waited out (1935: 99). Credit-induced booms induce activities which tend to restore the initial equilibrium position of the economy - even if that position is never attained (1939: 6). The equilibrium rate of interest will not be changed by any ‘purely monetary’ credit expansion, because the corresponding shifts in the structure of production fail to coincide with the given intertemporal preferences of the consumers (1933: 221ff, 1941: 406f). Even though money is bound to be non-neutral in the short run, it tends to be neutral in the long run. In Hayek's words, money may be a loose joint in the price mechanism, but it does not break the mechanism. March 4, 2016 3. Hayek‘s Austrian theory of the business-cycle