[Published on 16 December 2011 at Mises.ca.]

It would be unfair to speak of the Austrian resurgence without highlighting the importance of the academic revival that the Austrian school enjoyed between around 1974[1] and the present day. However, there is no doubt that the financial crisis which began in late 2007 and continues in some form or another today made obvious the relevance of Austrian economics to a much broader crowd of non-academics (and future academics). Political discussion on debt, stimulus, quantitative easing, and other forms of economic interventions has brought to question their necessity, and in turn this has invoked the economic insights of the Austrian school regarding interventionism and the market economy. Using Austrian insights, some have begun to ask themselves if there is any theoretical justification for the interventions government promises will bring the economy out of stagnation.

The convergence of the political and economic debates brings to memory a similar debate which dominated during the mid-1930s, between Friedrich Hayek and John Maynard Keynes. The topic of discussion was almost identical to that of today, although the theoretical tools used by both sides have sharpened since. Hayek and Keynes disagreed on the nature of the crisis and, consequently, on the method of recovering from it. Keynes, broadly considered, supported the use of monetary and fiscal stimuli to put to use unemployed resources, thereby aiding the recovery of aggregate demand. Hayek rejected this approach, since it ignored many of the microfoundations which define the nature of the market process, and instead suggested a means to recovery which relied on the personalized economization of resources by the individuals which constitute the market.

Thanks to the work put in by the new generations of scholars during the past four decades, there is a revitalized (and improved) body of Austrian theory that can be involved in today’s debate. There is a new case to apply the teachings of Hayek, Ludwig von Mises, and others to contemporaneous events. The growing popularity of Austrian theories has begun to form a threat against the Neoclassical-Keynesian orthodoxy, and all related subsidiary schools, which continues to govern the economics profession. One fundamental theory is that of intertemporal discoordination — Austrian business cycle theory — which attempts to explain the causal reasons behind depressions, and using these insights as a starting point for explaining what needs to occur once the crisis begins.

The authority and applicability of the Austrian theory of the business cycle has been challenged in a recent article by economist David Warsh. Warsh’s argument is that Hayek’s business cycle theory was deemed, at the very least, inadequate in the late 1930s, which explains Keynes’ eventual dominance in the debate. If Hayek’s ideas on business cycles had little impact on the profession, this should suggest that their soundness is suspect. Furthermore, according to Warsh it was Milton Friedman — who won the Nobel Memorial Prize in Economics in 1976, two years after Hayek — who provided the explanation for the Great Depression, once and for all upending any case the Austrians may have had. Warsh’s overarching point: there is no reason to favor the Austrian story of depressions over the Neoclassical-Keynesian explanation.[2]

Paul Krugman, inspired by Warsh’s article, took the issue one step further. According to Krugman, Hayek “made a fool of himself” in the early 1930s, and his economic ideas have only resurfaced because his political work appeals to the American right. Specifically, Krugman argues that it is this political appeal which has caused Hayek’s legacy as an economist to be artificially inflated retroactively. He makes the explicit claim that had Hayek’s political work remained ignored, then so would have his work on the business cycle. That is, Hayek’s theory of capital is not important on its own standing. Krugman took Warsh’s semi-defensible thesis and distorted it as a means of undermining Hayek’s authority.

No doubt, Friedrich Hayek’s role in the development of mainstream economic science after the Second World War is marginal, at best. However, Warsh and Krugman err in their beliefs that the obscurity of Hayekian business cycle theory proves its irrelevance and inaccuracy. Neither takes into consideration how important Hayek and other pre-war Austrian economists, including Mises, are to the modern Austrian movement. This suggests that if the Austrian paradigm is ever to replace the Neoclassical-Keynesian orthodoxy, then Hayek and Mises indeed contributed greatly to science. One would be absolutely correct in making the claim that Hayek and, especially, Mises were crucial figures in the development of economics.

The point is that the relevance of the Austrian argument cannot be judged on how influential, or non-influential, it has been on mainstream economics since the late 1930s. Austrian contributions cannot be weighed based on their popularity. Warsh’s and Krugman’s commentaries essentially amount to red herrings, since they attempt to undermine Austrian theory by shifting focus to the irrelevant fact that neither Mises nor Hayek were important figures in the Neoclassical-Keynesian synthesis which followed the Second World War. The fact is that the value of Hayek’s contributions — and any other economist’s, for that matter — cannot be judged on a historical basis, rather they must be judged on the basis of their internal accuracy.

Hayek v. Keynes: Macroeconomics during the 1930s

By 1930, the Austrians were in good standing with the economics profession. Mises’ contributions to the socialist calculation debate were widely recognized and respected, and Hayek was an up and coming theoretician. Böhm-Bawerk’s work on capital theory, while not entirely assimilated, still formed an important part of that era’s corpus of economic knowledge. The Austrians were well “inside the mainstream”, in the sense that their beliefs were still held in relatively high regard and that they were acknowledged as important and relevant economists.

Hayek was invited to the London School of Economics (LSE) by Lionel Robbins, who had just recently become the university’s head of the department of economics. Prior to Robbins’ ascension, the LSE had remained one of the last universities in England that defended a historicist approach to the social sciences — contra theory. Robbins looked to transform the LSE into a major center for theory. He also looked to combat the growing narrowness of British Marshallian economics and erect an anti-Keynesian — Keynes, at that time, being a very popular British economist just returning into the realm of theory development — stronghold. Along with Hayek came economists such as John Hicks[3], Nikolas Kaldor, and Abba Lerner.

At the LSE, Hayek gave a series of lectures, later published as Prices and Production. The lectures, while perhaps not very understandable, became quite popular and they earned Hayek a more permanent stay in England. Soon, Hayek used his heightened reputation to join battle with Keynes. The first major blow was struck by Hayek in his review of Keynes’ Treatise on Money. Keynes struck back through the recruitment of Piero Sraffa, who reviewed Hayek’s Prices and Production.

The discussion was very similar to the modern austerity versus stimulus debate, although at the time the major players were still busy fully developing their theories. Keynes favored temporary and limited government socialization of investment as a means of using unspent money to recover the “gap” in aggregate demand, as well as general monetary stimulus. He believed that banks do not do an adequate or complete job in financial intermediation through the loanable funds market — a form of disconnect between savings and consumption. More specifically, he did not see a reason as to why savings are necessarily invested, seeing this as a natural fault in the capitalist system.

Hayek essentially agreed that the business cycle was characterized by a massive loss in investment and productive capabilities. It was in his identification of the causes for this loss where he differed with Keynes. The differences in business cycle theory also led Hayek to radically different ideas on the nature of the recovery.

In short, Hayek borrowed from Mises the idea that an increase in the supply of money distributed through the loanable funds market could distort the prices of capital goods relative to consumer goods. This would lead to an investment boom which would gradually spread up the structure of production — this facet formed the crux of Hayek’s work on business cycle theory in Prices and Production. However, investments require capital goods, and by distorting prices what occurs is an increase in the quantity demanded without a previous increase in their supply. The insufficient quantity of capital goods leads to the necessary liquidation of impossible investments, once prices increase enough to reveal their unprofitability — what Mises and Hayek term “malinvestments.”

While the recession is characterized by the mass liquidation of malinvestment, what this really entails is a capital restructuring. The different processes of production that make up an economy must be reorganized in accordance with consumer preferences, including intertemporal preferences (the relationship between savings and consumption). This process of reorganization is carried about by the individual capital-controlling entrepreneurs, each of which uses her best judgment in economizing her stock of capital goods.

Mises and Hayek saw government expenditure as counter-productive, because it negatively intervenes in the process of economization. In other words, on average, government socialization of investment — whether it manifests through forced wealth redistribution or actual public investment (e.g. public works) — leads to less productive outcomes than what the alternative would have been had those resources been only been economized in the market process. More elementarily, since government acts outside of the profit and loss jurisdiction, government cannot accurately calculate the net (un)profitability of its investments.

When in the 30s it seemed that maybe the Austrians would gain an ever wider appreciation, the school of thought took two particularly hard hits,

Oskar Lange’s 1938 rebuttal in the socialist calculation debate;[4] Sraffa’s review of Prices and Production, in conjunction with the publication of Keynes’ The General Theory.[5]

Lange’s case for socialism was quite clever. If specific points of equilibrium existed for each good and if economists could model this equilibrium, argued Lange, then socialist planners could use equilibrium prices to construct a rough system of accounting. He had, in effect, exploited a major weakness in the Marshallian tradition to undermine the neoclassical case against socialism. It was a great victory, and the Austrian response came as too little and too late.

Marshallian economics took another great blow, and this time lethal, in the form of The General Theory. Keynes managed to turn “classical economics” on its head and tear it to pieces, shattering whatever theoretical ground it had to stand on. Keynes’ reforms to Marshallian theory were so sweeping precisely because he had so effectively undermined the premises that most economists had accepted by then. This reformation gave way to the Neoclassical-Keynesian synthesis, spearheaded by the brilliant Hicks, of the 1940s and 1950s.

Hayek and Mises were dismissed along with the Neoclassicals. Both were so preoccupied with the socialist calculation debate that they did not make the effort to differentiate themselves sufficiently from their Neoclassical allies. Thus, Austrian economics was taken as an extension of the mainstream and it was discredited on the basis of guilt by association.

Furthermore, Hayek’s capital theories had been partially disproved by Sraffa’s criticism of Prices and Production, denying the reeling economics profession from any better alternative. Sraffa questioned Hayek’s business cycle theory by focusing on the nature of the rate of interest and arguing that if different goods had different degrees of intertemporal preference, then how could one objectively decide whether the market rate of interest was “too low” or “too high.” While Hayek managed a limited rebuttal in 1937 in the form of his article “Investment That Raises the Demand for Capital,” his most important and complete contribution to the capital debate did not come until 1941. When The Pure Theory of Capital was finally published the profession no longer cared.

While it is true that the Austrian school was condemned to the margin of economics, Krugman’s recounting does not do the story justice. Neither did Hayek “make a fool of himself” nor did his “ideas [vanish] from the professional discussion.” Hayek, and the Austrian school in general, had suffered a number of setbacks, largely related to the fact that they had not sufficiently distinguished their tradition from the Marshallian one. Hayek also took flak from the fact that his theory of capital, which was still in development, had not been as nuanced and/or consistent as something more mature would have been.

Really, though, it was not that Hayek had been disproved; rather, by the time Hayek re-entered the debate, the time for debate had already passed. Sraffa convincingly critiqued a very limited portion of Hayek’s theory of capital, and the profession threw the baby out with the bath water. When Hayek finally finished the polished version of his thoughts nobody was there to listen. It was not that Hayek had made a fool of himself; the relevance of his work was no longer seen. Hayek’s more refined contributions had come too late in the game, and whatever he was able to put out there was too undeveloped to stand up to the criticism.

This is not to suggest that Austrian insights played no role in the development of modern mainstream macroeconomics. Mises’ initial criticisms of socialism, namely his emphasis on the role of the pricing process in coordinating the use of resources, caused an important turning point in the debate — without Mises, the face of macroeconomics would have looked very different. Different aspects of Hayek’s work influenced and inspired future theoretical developments, although perhaps in directions that Hayek himself would have never endorsed. For example, Joseph Stiglitz’ theories of asymmetrical knowledge were partly inspired by Hayek’s work on knowledge dispersion.

That neither Mises nor Hayek, or any other Austrian, were as important as Keynes — or even Hicks — in the development of modern macroeconomics is not necessarily a bad thing. Neither does this fact make Austrian economics irrelevant. To somebody of the opinion that economics took a turn for the worst with the adoption of Keynesian ideas, it simply means that the Austrians had done an inadequate job of persuading the profession of their particular framework. At the same time, however, this may have been an impossible task, given that the Marshallian tradition had taken such a firm hold in England. However, the fact that the Austrians were not wholly vital to modern economics does not discredit their theories.

Rather than being the time to dismiss Austrian economic theory, it may be a better time to finally push for that paradigm shift in economic science. Perhaps, more than ever, it will become obvious that the Neoclassical-Keynesian orthodoxy is just as flawed as the Neoclassical school it replaced. Economics is a science that is ever changing, and for all we know Hayek and Mises may be more important to the future of economics than Warsh, Krugman, and others give them credit for.[6]

Intellectual Rebirth: The Modern Austrian School and its Importance

The 2007–08 financial crisis and the consequent Great Recession has brought to trial the accuracy and applicability of mainstream economics. As the crisis unfolded, economists of all schools pointed at each other. The economic crisis has caused a crisis within the economics profession itself, and what resulted was a vacuum of ideas. This emptiness was eventually filled with the return of various heterodox schools, including a new radical New Keynesianism — one which proposes massive monetary and fiscal stimuli as a means of employing “idle resources” and changing expectations — and a resurgent Austrian school.

David Warsh and, more crudely, Paul Krugman have tried to undermine the rise of the Austrians by pointing out Hayek’s inability to persuade the profession of his ideas in the 1930s. That Hayek, and other Austrians, were unable to spark an “Austrian Revolution,” though, is not a sign of irrelevance or theoretical weakness. Hayek suffered a temporary setback in the form of Sraffa’s criticism, and when Hayek came back reinforced with a much more mature capital theory the profession had already moved on thanks to the publication of Keynes’ The General Theory.

All of this said, it ignores the monumental role figures like Mises and Hayek have played in the formation of a modern Austrian school. While perhaps the school experienced a low point during the late 1940s and throughout the 1950s, it saw a sudden resurgence under the intellectual auspices of economists such as Murray Rothbard, Ludwig Lachmann, and Israel Kirzner. This generation of Austrians would breed a newer and larger one, which are now the academic leaders of the school and have carried the revival between the mid-1970s through to the present day.

Just as important, the growing popularity of the school has inspired a great many young scholars to adopt Austrian ideas. What this means is that the next generation of Austrians will be even larger than the current one. For these young academics Hayek and Mises will be amongst their most important influences. This suggests that Hayek, Mises, et alii, will be important influences on whatever paradigm takes hold in the economics profession in the future.

Warsh himself alludes to this, commenting that, “Hayek may yet enter history as a prophet of evolutionary economics.” It is true that Hayek, and to a greater extent Mises, were economists in a rich tradition which emphasized the role of economization and the nature of the dynamic market process (versus a static market). It is also true that economics seems to be moving in the direction of dynamism — even mainstream equilibrium models are beginning to trudge towards dynamism.

All considered, the Austrians are growing in importance, relevancy, and influence. Whether Krugman and others are willing to admit it or not is not important. Like that of Hayek and Mises, Krugman’s and others’ legacies will be decided by future economists. Fortunately (or, unfortunately, for some), the future looks increasingly Austrian.