Boiling it down.

|Peter Lewin|

Keynesian (and some Monetarist) versus Austrian views on the business cycle revolve around two basic empirical issues: the nature of capital and production and the nature of the national budget constraint.

Concerning capital: Ironically, Keynesians appear to assume a kind of “equilibrium always” story in which productive (human and physical) resources can, at low cost, be simply shifted to and plugged in to the production of whatever product or service happens to be the object of demand stimulus; and, further, that if enough of this is done, income, employment and tax-payments will rise precipitously. In this way economic-policy can produce economic growth that will expand the budget constraint sufficiently to be able to pay off the large past deficits (the accumulated national debt).

Austrians maintain that both of these (connected) assertions are false. Productive resources are not fungible. They cannot be easily moved and reassembled to produce whatever has been arbitrarily stimulated. The formation of productive resource combinations is the spontaneous result of idiosyncratic entrepreneurial judgments about future demand and revenue. There is nothing mechanical about it. Amorphous stimulus spending is not likely to produce an environment which entrepreneurs are willing to bet on. Rather, the result will be a malaise of uncertainty and reluctance to borrow and lend. The intertemporal budget constraint is real, not only for private citizens, but for the nation as a whole.

We cannot spend our way out of debt by hoping that the spending will lead to growth, especially when those doing the spending have no idea how to plant the seeds.

Comments

[EricK]

Do you have any thoughts about Steele's point here?

http://socialdemocracy21stcentury.blogspot.com/2012/06/why-isnt-boom-of-1946-1948-problem-for.html

"Since the claim that physical incongruities are crucial is an empirical claim, I was then struck by the experience of the US at the end of World War II. If ever there was a case of an abrupt, almost overnight, mismatch between prior allocations of capital and today’s applications, we could hardly imagine a more spectacular example. Millions of people left the army and found civilian work. Hundreds of thousands of factories which had been producing military goods had to transform their operations into civilian production. Why was the whole system not seized by a violent slump?

To the purely monetary approach, this is simple and obvious. There was no violent contraction of the money supply, so there was no slump. But to the Austrians, what explanation could there possibly be? Their claim is that once the boom has got going it cannot be ended without a slump, and that this is so because of the need to suddenly re-allocate physical assets to completely new uses. But that re-allocation was obviously thousands of times greater in 1945 than it could ever be as the result of a few years of bank credit expansion, and yet there was no slump! The whole system adapted to the utterly changed conditions with amazing ease and smoothness."

[McKinney]

EricK, the answer lies in expectations. No one expected the war to last forever. Everyone new it would end and when the timing of the end became clearer, such as after the successes following D-Day and the conquest of Okinawa, companies began planning for the transition.

On the other hand, businessmen really do expect the good times to last longer than they do, especially in the capital goods producing industries. That's partly due to bias and partly to mainstream economic theory.

Keep in mind that the end of WWII took no one by surprise, but every single recession since then has taken mainstream econ by complete surprise.

[Jonathan M.F. Catalán]

EricK,

As I've written elsewhere, there is a key difference in how capital consumption is brought about. The Great Depression was preceded by a boom which, according to the Mises-Hayek theory, brings about price distortion and consequent malinvestment. What results is a depressionary phase where this malinvestment is liquidated and many of the capital goods produced lose their value as production readjusts to consumer preferences.

During the Second World War, the capital consumption is partially of another kind. There is an aspect where the machinery is useful for producing weaponry, but there is also capital consumption in that much of the output was consumed during the war. So the consumption is direct, not necessarily entirely indirect.

In short, the business cycle has a boom-bust pattern, where the Second World War and the consequent boom had a bust-boom pattern. During the Second World War the economy was already depressed; what occurred was further capital consumption, but when markets finally began to be liberalized (by lifting restrictions on consumption and production) there was no contractionary chaos that entrepreneurs had to deal with.

[EricK]

Thanks for the explanations.

[Peter Lewin]

Good question, and the follow-on comments. I wonder what diverse opinions about Steele's interpretation of the data there might be. Though I like Jonathan's appeal to the particular nature of the capital structure and the state of the macro-economy at the time,I am not an economic historian, so I cannot weigh in on whether or not this episode is a challenge to the Austrian malinvestment assertion. I wonder for example how Robert Higgs would answer this question. Maybe someone knows.

[Peter Lewin]

I found this in the comments section of the link provided for the Steele quote:

"It is not correct to say there was no slump in 1946. A contraction of real output did occur, as the wartime command economy ended:
Year | GDP* | Growth Rate
1941 | $1,366,100 | 17.07%
1942 | $1,618,200 | 18.45%
1943 | $1,883,100 | 16.37%
1944 | $2,035,200 | 8.07%
1945 | $2,012,400 | -1.12%
1946 | $1,792,200 | -10.9%
1947 | $1,776,100 | -0.89%
1948 | $1,854,200 | 4.39%
1949 | $1,844,700 | -0.51%
1950 | $2,006,000 | 8.74%
* Millions of 2005 dollars
http://www.measuringworth.com/datasets/usgdp/result.php

But the point that the private sector was expanding in other areas at the same time is well taken: this period was one of massive capital conversion and liquidation, and yet unemployment did not become a problem and the normal private economy producing consumer goods expanded rapidly."

If these numbers are right it does not look as if the 1945-1950 adjustment was easy at all - quite the contrary.

[Troy Camplin]

Not even writing is fungible:

http://theliteraryorder.blogspot.com/2011/09/writing-is-not-fungible.html

[Bill Woolsey]

Lewin:

I don't assume that capital can be costlessly reallocated. On the other hand, my view of the world is one of continuous costly reallocation. What makes you think that any misallocation that occured because of a past excess supply of money is more significant than the myriad of misallocations that developed because China gave up on communism and introduced export led growth, or the development of the internet or any of the other changes?

It is Austrians that are abstracting away from the market process of creative distruction and instead imagining what would happen if we really did live in an ERE at it were distrupted. There is no ERE.

Anyway, regardless of how difficult it is to reallocate resources, what is the best environment for readjustment? Consistent growth in demand for output? Shift to a lower growth path? Shrinkage?

If you assume that real output or unemployment is targeted, (which was the case 30 to 40 years ago) then if there is a decrease in potential output and an increase in the natural rate of unemployment due to a need to reallocate more than usual, then efforts to expand spending on output whatever amount is needed to get output back to trend or unemployment back to a target level could be disastrous.

If instead, the goal is to keep spending on output growing at a stable rate, then if there is a need to reallocate resources, then the prices of output rise more for a time. The demand for things people want more rise more and so do prices and profits. The demand for things they want less rise less or fall, resulting in prices rising less or falling and lower profits or losses. The composition of output changes to reflect demand.

As for fiscal policy, I think the reduction in revenue when output falls given constant rates is helpful. Raising tax rates to maintain what the government takes would be really bad. I don't think cutting government spending to balance the budget in that situation is wise either.

Of course, there might be other things going on. Still, I think the monetary regime should be responsible for keeping spending growing at a stable rate regardless of fiscal policy.

P.S. If you want to use the post WW2 "recession" as an example of an Austrian recession, feel free. People who know something about it would say, "yes, that is the kind of "recessions" we should have, where there demand for private consumer and capital goods are booming and unemployment for labor stays low."

[Jonathan M.F. Catalán]

Bill,

Why suggest that Austrians are using the ERE as a model? What Austrians have invoked the ERE in their discussion of structural readjustment? In fact, what I've read has usually assumed the real world of disequilibrium and rigidities. Neither have I read any Austrians who suggest that these readjustments occur without cost (in fact, capital consumption is an important aspect of the Mises–Hayek business cycle theory; see Hayek's "The Maintenance of Capital" and "Investment That Raises the Demand for Capital" — the latter especially, since it considers capital consumption and the structure of production once the former takes place).

What defines the Mises–Hayek theory is the role of money prices, and the part that monetary expansion may play on distorting these prices. So, while public investment can have a large opportunity cost in that a private allocation may, in general, produce more "optimal" results, this is different from boom-time malinvestment in that this latter phenomenon is caused by a fundamental misevaluation of its value. Public investment and similar forms of poor investment don't necessarily have this characteristic of distortion of value, and so while the investment can be a bad one relative to the alternative they're not necessarily unsustainable.

Austrians have also extensively discussed handicaps to structural readjustment — the obvious example is regime uncertainty. Another example is the status of private debt, the volume of bad debt, and moribund status of the banking sector. This latter example, I think, isn't emphasized enough by Austrians, although it has been tended to be emphasized by post Keynesians. It's, unfortunately, essentially handwaved way by market monetarists, who think that if they can maintain NGDP (through some unknown, almost mystical, mechanism) the debt problem is solved (they don't even consider the possibility that it may only postpone the problem).

Finally, my problem with the output story is that demand on final output has pretty much recovered. So, the problem isn't just about final demand, but also demand for intermediate products. If this demand for intermediate products can't be sustained, this necessitates a readjustment (this is, by the way, almost straight out of Hayek's "Profits, Interest and Investment"). I'm not sure liquidity injections can maintain this demand, because liquidity injections can't target specific entrepreneurs. You can't prop up the value of certain intermediate goods — this type of control just isn't possible, and if it were I'm not sure it would be healthy.

In short, I do think that the Austrian story does hold water — even if it's true that it can be amended and made more robust. But, there are reasons to doubt the necessity for monetary or fiscal injections. This isn't to suggest it's an absolute opinion; but, there is a debate to be held and there's no obvious reason to choose market monetarism over Austrianism.

[Allan Walstad]

Catalan: A very polite and thoughtful response to Woolsey. Equally accurate and more concise, though perhaps less informative, would be simply to note that Woolsey has a propensity to demolish straw men of his own creation.

For Austrians, the ERE is simply an analytical foil; one seeks to better understand entrepreneurship and economic change by starting from a hypothetical situation in which there is none. To assert that Austrians think we are, or sometimes are, living in an ERE bespeaks a startling lack of attentiveness.

Actually, of course, the post-WWII experience is a huge problem for Keynesians. With the war spending subsiding, with all those troops coming home and joining the work force, why wasn't there a terrible depression? The answer in part is that FDR was gone, along with his destructive hyper-interventionism. The market economy is resilient, if allowed to work without continuing massive distortion. Let entrepreneurs operate in a market where price and interest signals are not distorted, and they will rapidly and effectively get down to the business of assembling the capital to generate the goods and services people want.

Turning attention back to the thread at hand, Peter Lewin's post is right on target. Capital is not infinitely malleable or fungible. Monetary and fiscal stimulus generate distortions in the structure of production, and further stimulus does not straighten these out. A distorted structure of production inevitably means a reduced output in the short run, unless you can get people to work longer and harder for no increase in real income.

Unfortunately, this brings me back to Woolsey for a moment. We all know that entrepreneurial errors are occurring all the time, and the resulting malinvestments are eliminated in the course of the ordinary market process. The problem comes with a buildup of large, systematic malinvestment stimulated and then often maintained by government intervention. The difference might be analogized to the normal course of events for the human body, where undesirable germs enter and are eliminated, versus a situation in which the immune system is weakened ad a bad infection results. At any rate, if anyone does not understand the difference between the usual cauldron of market activity on one hand, and a bubble on the other hand, that person is not in a position to criticize the Austrian analysis of how we got in a mess and how we might get out.

[Bill Woolsey]

Walstad:

Don't be so defensive. The ERE is just a foil.. Not only have I read this, I have said it.

I do deny that any impact of an excess supply of money on the allocation of resources is any more signicant that any of the other "ordinary" malinvestments that are the "normal" part of economic activity.

If spending on output shifts down to a lower growth path, the result is a recession. How many reallocations of resources are going on at the same time is not very significant.

I have mentioned some very large and significant shifts that don't have to do with an excess supply of money, and you just assert that the excess supply of money creates far reaching problems. Why?

Catalan:

The point isn't that public expenditures are unsustaintable. It is that when they are shifted this is a large shift in the profitable allocation of resources.

So, the U.S. could have continued on a war footing permanently after WW2. Instead, there was a substantial demobilization. The private sector boomed. There was no significant unemployment.

What happened is that spending on private goods grew rapidly.

You said before that the war was not expected to be permanent. Why would anyone expect that an excess supply of money will be permanent?

The problem with this entire theory that excess supplies of money have these long lasting effects on the structure of production is that no one can possibly base any specific investment today on a pattern of final demand in the future, and so what discount rate is used is just a minor factor tied in the kalediscope.

If the current fed funds rate reflects the interest rate in 2018, then this will impact whether optimal durability of the drill press machine that will be constructed with the steel that will be made with the iron ore that will be produced with the bulldozer I am making now. No one can possibly have anything like the information to make these judgements. Sure, having the interest rate wrong doesn't help. But it is a drop in the bucket of uncertainty.

If the interest rate is not just right, it is impossible to create a sustainable structure of production. But just because the interest rate is just right, doesn't mean that today's specific investments will be sustainable. There might not be problems of duration, but there are huge problems of composition. The reality is that todays investments will never be sustainable.

We are constantly making new plans out of the wreckage of the old ones.

What is the best environment for this process to occur. I say, slow steady growth in spending on output. Higher and higher each year. When production grows less than usual, prices rise more than usual. When there is more malinvestment than usual, unemployment is higher than usual.

But nothing is helped by having nominal expenditure drop. It is always a bad idea for spending to fall on something that people want more of, and having this work out because spending falls even more on the things they want less of.

Larger increase on the things people want more off, and slower spending on the things people want less off. Pull the resources towards what is underproduced. Don't try to push them them out of what was over produced.

If the wrong capital goods exist now, and the demand for their products rise, then the prices of those goods rise, as do their profits. This creates and incentive and funding to buy those capital goods, motivating their production.

As the capital goods are produced and prodction expands, prices can drop back down.

Why is this a problem?

[Allan Walstad]

Woolsey -- Artificial credit expansion creates problems for the reasons well-explained in Austrian theory. Other things going on might also create problems at various times -- there is no logical contradiction there. I agree with the consensus among Austrians that government manipulation of the money supply, together with the oft-associated fiscal profligacy, has been responsible for causing and prolonging boom-bust cycles.

"If spending on output shifts down to a lower growth path...." Geez. This is just the Keynesian presumption that output is limited by consumption. No, consumption is limited by output. People around the world and down through history have preferred more and better over less and worse. If a downward shift in consumption reflects increased saving that can be invested in capital formation, is the very basis for a higher growth path. When the structure of production has been distorted by government intervention, the repair of that structure will take resources wielded by entrepreneurs guided by price signals in a functioning, undistorted market. In the short run, this requires less consumption, not more. There is no getting around these underlying physical realities. Fiscal and monetary stimulus under these circumstances is like trying to fix a malfunctioning auto by pushing down harder on the gas pedal.

[Peter Lewin]

I hesitate to step in here - especially when Jonathan and Allan seem to have it covered (at least from my perspective). Just one small point: On Bill's observation that all kinds of intervention-caused distortions should have the similar adjustment costs to those alleged in the ABC story. Maybe, but only is they are systemic, which is very rare. China moving from communism to free markets doesn't seem comparable. Under communism the economy was at a very low, unproductive level - a sort of chronic depression. Freeing up markets moves it permanently to a higher level - not without cost - but this is not a cycle. Macroeconomic policy distortions create bubbles - high performance resource employments that cannot be sustained - therefore presaging a bust - a cycle, a run-up and a run-down before a recovery.

Clearly every cycle is different. I would not suggest that the structural distortions are the same in each case.

It may also be of interest to note, that in explaining cycles, the Monetarists assert for the labor market something similar to what the Austrians assert for the capital-goods market - unsustainable over-employment as a result of a distortion of the real-wage, followed by an increase in unemployment (above the natural rate) caused by what - costly readjustment?

[Jonathan M.F. Catalán]

Bill,

I think the emphasis on changes in the rate of interest is a bit misleading. It's not just changes in the rate of interest that lead to the Mises–Hayek theory. It leads to changes in the rate of profit for various industries at various stages, which suggests that what really matters is the change in the relative prices of goods. So, what really induces investment in later stages is an increase in the value of the output of that stage, not a reduction in the rate of interest.

So, my point when comparing the boom–bust and "bad" investments that occur when the isn't severe intertemporal discoordination is that in the former the values of the goods in question are distorted; this is not true in the case of the latter — this should be recognized as a fundamental difference.

With regards to nominal expenditure, I think it's easy to agree with your argument. But, one thing that has always troubled me is that while entrepreneurs are said to be tasked with coping with changes in consumer preference, the one change they seemingly can never deal with is a change in the pattern of expenditures. And, I repeat, I'm not sure liquidity injections can re-create the pattern of spending that would have existed prior to the increase in the demand for money; so, in the end the same price adjustments have to made. This is more or less the criticism I make in my short piece: "Prices and the Demand for Money."

[Lord Keynes]

"There is nothing mechanical about it. Amorphous stimulus spending is not likely to produce an environment which entrepreneurs are willing to bet on. Rather, the result will be a malaise of uncertainty and reluctance to borrow and lend."

The empirical evidence from history proves you wrong.

From 1945-1970s, Keynesian stimulus was regularly applied in nation after nation after nation, and economies boomed.

For instance, why did Keynesian stimulus work in the US in 1948-1949, 1953-1954, and 1957-1958?

[Bill Woolsey]

Lewin:

The point I was making wasn't about conditions in China. It was rather invesments in U.S. production processes that turned out to be unprofitable when faced by Chinese competition. If China had continued under Maoist policies, then that competition would have never occured. Human and physical capital in the U.S. specific to say, toy production, would have been profitable.

Misallocation due to an excess supply of money only a drop in the bucket of misallocation because of the constant change.

I think there was a housing bubble that involved substantial misallocation of resources. Nothing worse than many other missalocations of resources, but substantial. I don't think an excess supply of money was a significant cause of the housing bubble. And so, that part, (if any) of the housing bubble due to an excess supply of money was trivial compared to other misallocations for resources due to changes in technogology, international and domestic competition.

[Peter Boettke]

Lord Keynes,

It is called the economics of illusion ... Albert Hahn got this right years ago. Our current problems are not a decade old, but six decades old -- see Kotlikoff on intergenerational accounting, and Buchanan and Wagner on why this "fiscal child abuse" is the political legacy of Lord Keynes.

[Bill Woolsey]

Walstad:

Consumption is one type of spending on output. Investment is another. Spending on output includes both. A lower growth path of spending on output is a decrease in investment, consumption, or both. (Or maybe one increases, and but the other decreases more.)

"Artificial credit creation?" You are too focused on the thought experiment of an increase in the quantity of money issued in the form of loans, given the demand to hold money, the supply of saving, and the demand for investment. You need to move on to scearios where the demand to hold money, the supply of saving, and the demand for investment are all shifting about.

If there is an increase in the demand to hold money, an increase in the supply of saving, and a decrease in the demand for investment, then an increase in the quantity of money and a lower market interest rate are coordinating. Using a thought experiment of what happens when there is an increase in the quantity of money with unchanged demand to hold money, an unchanged supply of saving, and an unchanged demand for investment is severely mistaken.

Is it artificial? Compared to what? A constant quantity of money? A gold standard with 100% marginal gold requirements for base money? These are all monetary regimes that have their own consequenes. There is nothing "natural" about the quantity of money or interest rates that the generate. Alternative monetary regimes, like keeping spending on output on a slow, steady growth path have different implications for the quantity of money and interest rates. But there is nothing more or less artificial than any other.

Even if we did live in a world were money and banking had freely evolved, I would not count the quantity of money and interest rates genereated by the system as "natural" and any alternative framework as "artificial."

Excess supplies and demands for money create problems. I don't think that the impact of an excess supply of money on the allocation of resources (producing for more distant future dates) is especially more disturbing than any of the myriad of other shifts in the allocation of resources. But that doesn't mean that excess supplies of money aren't a bad thing and that whatever misallocations that are created are OK. It is just important to get a sense of proportion.

[Bill Woolsey]

Catlans:

A careful analysis of money and credit shows that there is _no_ problem if the quantity of money adjusts to the demand to hold it. Of course this will not resource in the allocation of resources returning to their initial level. Why should it?

If the quantity of money adjusts to the demand for money, and there is a credit money system, then the result is the same as if people accumulated other sorts of finanical assets rather than money. The banks are just serving as intermediaries, buying those other fiancial assets in place of those accumulating money.

If people decided to spend less on consumer goods and buy bonds, the result would not be that the allocation of resources returns to its initial level. If people decide to spend less on consumer goods and accumulate money, and banks issue new money and buy bonds, then the result won't be that the allocation of resources retuns to where it was before.

If firms cut back on purchases of capital goods and buy bonds, then the result is not going to be that the allocation of resources returns to the initial level. If firms cut back on purchases of capital goods and accumulate money, and banks issue money and buy bonds, the result isn't going to be that the allocation of resources returns to where it was before.

But the result is the same as if the households or firms bought the bonds.

There is no need to give money to people who want to hold more so that they continue to spend exactly like they were before. That isn't the goal.

The goal is to avoid the need for a deflation in prices, including resource prices like wages, to bring the real quantity of money up to the demand to hold it. The pattern of expenditure changes. The pattern of expenditure is changing all the time.

As for the claim that the values are wrong with intertermporal discordination but not with changes in technology--what? The values that were generated based upon the wrong expecations turn out to be wrong. For example,the value of a specialized toy making machine in South Carolina turns out to be wrong when improved economic policies in China result in people buying more Chinese toys.

The values of each specific capital good today depends on specific things that will happen in the future. I think it is obvious that no one can possibilty actually have some kind of detailed decision tree covering all possibilities. But that short term interest rates today are consistent with some plan is just a drop in the bucket compared to all of the other things that must go right.

I don't deny that if interest rates are different than people expected, then some capital goods will be less profitable than expected. But imagining that the economy is a detailed tinker toy perfectly optimized to some perfectly anticipated interest rate path, and that disaster occurs with those expectations are frustrated, just seems pretty unlikely.

[McKinney]

“I do deny that any impact of an excess supply of money on the allocation of resources is any more signicant that any of the other "ordinary" malinvestments that are the "normal" part of economic activity.”

Bill is right if we take a very long term view of things. But as Keynes wrote, economists do us no good if all they can tell us is that after the storm the ocean will be calm. Of course, Keynes fixated on the very short run.

In the intermediate term, monetary expansion causes far more problems than “ordinary” malinvestments because money changes the relative values of capital goods to consumer goods. That changes profits, which guide investment.

Other ordinary malinvestments happen on a much, much smaller scale. Changes in money affect the prices of all goods. Changes in technology, trade and ordinary business mistakes affect single industries, not every single produce and service in the country.

And by taking such a long, long view, Bill misses the fact that money doesn’t enter the economy by suddenly appearing to every person in the country at the same time. That was one of Friedman’s mistakes. Money enters the economy at specific places and spreads out through the economy over time, distorting every price in its path.

I have asked other rabid monetarists what causes consumers to suddenly demand to hold more cash. I have yet to get a response. They refuse to consider that the demand for holding more cash is a description of a recession, not a cause.

[Peter Lewin]

Bill: I should have read what you said on China more carefully.
On the housing bubble - certainly a large and crucial part is played by the housing policies. Could the bubble have occurred without easy money? Are you suggesting this was a purely "real" cycle?
How about dot.com? Did easy money play a role in prolonging the boom?

[Bill Woolsey]

I think it is possible to have a bubble without an excess supply of money. It just crowds out other types of expenditure.

In the U.S., I think it was mostly import competing goods that were crowded out by the housing bubble. But it could have been other types of capital goods.

As far as policy is concerned, I think the key problem was the specific rules for risk-based capital requirements. Mortgage backed securities were treated as being more safe than other sorts of loans.

Still, I think bubbles are about people buying assets because their prices went up in the past, and others buying what they know are overpriced assets thinking they can sell out before the crash.

The real problem with mortgage backed securities was that the people holding them in money market mutual funds thought they could always sell out before losses became too severe.

I don't think there was "easy money" during the period because nominal GDP was below its trend growth path. Those like White and Selgin who say that there was are doing growth rate targeting. I don't think that is the right approach.

As for the dot.com bubble, I think there was "easy money"during that period, because nominal GDP was above its trend growth path. On the other hand, I don't think that the run up in stock prices was necessarily caused by the easy money.

I do worry sometimes about interest rate targeting. Worse, the new Keynesian approach to the zero bound of promising short interest rates for an extended period of time, is especially troubling. It seems like a policy tailor made (I was going to write, taylor made) to cause malinvestment.

I don't favor interest rate targeting.

[Jim Rose]

This a great post about capital (and labor) mismatch. More basically, it is about the second laws of supply and demand: short run-elasticities are lower than long-run elasticities.

All builds into other concepts such as time to plan, time to build, time to recruit, time to train, and learning by doing, learning about demand and learning by supplying.

[Josh S]

Not sure while Woolsey is saying there was no postwar unemployment. Unemployment jumped from around 1% at the apex of the war to around 4%, peaking at around 6% in 1949.

So yes, the reallocation of resources from building bombs and shooting rifles to building houses and fixing cars did indeed involve some idleness.

[lwaaks]

David Ramsay Steele has this criticism:

The distinctive thing about Austrian trade cycle theory is its view of "real" factors in the onset of the slump. Of course, much of what Mises and Hayek say overlaps with the "purely monetary" theories of people like Milton Friedman, and long before that, of people like Hawtrey. So there is no dispute that inflation of credit may create a phoney boom, followed by an uncomfortable period of adjustment. What is distinctive about the Austrian theory is that it says the specific physical form of the capital which is malinvested plays a crucial role in the onset of the slump. So, for example, if lengthening the production structure requires a particular type of big, expensive machine that has no use with a shorter production structure, then that machine will have to be written off as a loss, since it is not suitable to the "return to reality" when the boom is over.

What struck me very early about this (I think it crossed my mind when I read Rothbared's book on the 1930s depression, around 1971) was that it's an empirical claim, and at a quick glance, such physical incongruities don't seem to loom all that large. So, if the production structure lengthens, you change the shape of investment into something more appropriate to a lower time-preference. Fair enough. But what does this really mean? Let's say you have a factory. You start to use different types of machine tools, let's say. Still, most of your factors will be just the same, or almost the same, as before: electricity, computers (or in the old days, office stationery), unskilled workers, workers with various types of skill such as accountants, engineers, salespeople, and managers, your factory building itself, your use of trucks to get materials into the factory and products out, and so on. In others words, the overwhelming majority of the factors you employ are not specific to higher or lower orders of production. It's true that their application to specific tasks will shift a bit, but this goes on all the time, and is an inexact science at best.

Since the claim that physical incongruities are crucial is an empirical claim, I was then struck by the experience of the US at the end of World War II. If ever there was a case of an abrupt, almost overnight, mismatch between prior allocations of capital and today's applications, we could hardly imagine a more spectacular example. Millions of people left the army and found civilian work. Hundreds of thousands of factories which had been producing military goods had to transform their operations into civilian production. Why was the whole system not seized by a violent slump?

[McKinney]

Iwaaks, because it didn't happen "almost overnight." Businessmen weren't taken by surprise when the war ended. They had seen it coming for over a year and prepared for it. In addition, the savings rate was very high because of rationing, so the funds existed for re-tooling.

Also, I don't think you can understand the Austrian business cycle without the Ricardo Effect. The "lengthening" of production happens when businesses buy labor saving equipment. That happens when labor is expensive relative to equipment. This is the old labor/capital trade off of micro econ.

When the tables turn and labor becomes much cheaper than equipment, businesses employ more labor and buy fewer pieces of equipment, causing the slump in capital goods, the "shortening" of production, and the depression.

[Josh S]

Iwaaks, there are a couple problems:

1) There actually was a postwar slump. It just didn't last very long. Unemployment quadrupled, and GDP fell by as much as it did in the 1980 recession. So you guys, both sides, are arguing from a false premise. I think the problem is the postwar boom is what everyone remembers, and they assume that means there was no slump. You can see GDP numbers here: http://research.stlouisfed.org/fredgraph.png?g=8Wu

2) Economic theories typically try to hold as much constant as possible. But there was a very, very important variable that changed in the prewar and postwar period: the New Deal/wartime systems of price controls, cartelization, and rationing. Ending the heavy-handed suppression of the market economy (which Congress had to force Truman to do) was an extremely growth-friendly policy. If Truman had gotten his way, I doubt the postwar slump would have turned into the robust boom the USA enjoyed in the 50s.

[juicy couture handbag]

thank u for your sharing!

[Federico]

Wonderful. This pretty much sums up much of what is wrong with macroeconomics.