reflects an a priori commitment to laissez-faire

TO BE NOTED: From John Quiggan:

"Austrian Business Cycle Theory

By jquiggin | May 3, 2009

I’ve long promised a post on Austrian Business Cycle Theory, and here it is. For those who would rather get straight to the conclusion, it’s one I share in broad terms with most of the mainstream economists who’ve looked at the theory, from Tyler Cowen, Bryan Caplan and Gordon Tullock at the libertarian/Chicago end of the spectrum to Keynesians like Paul Krugman and Brad DeLong.

To sum up, although the Austrian School was at the forefront of business cycle theory in the 1920s, it hasn’t developed in any positive way since then. The central idea of the credit cycle is an important one, particularly as it applies to the business cycle in the presence of a largely unregulated financial system. But the Austrians balked at the interventionist implications of their own position, and failed to engage seriously with Keynesian ideas.

The result (like orthodox Marxism) is a research program that was active and progressive a century or so ago but has now become an ossified dogma. Like all such dogmatic orthodoxies, it provides believers with the illusion of a complete explanation but cease to respond in a progressive way to empirical violations of its predictions or to theoretical objections. To the extent that anything positive remains, it is likely to be developed by non-Austrians such as the post-Keynesian followers of Hyman Minsky.

First, some history and data. Austrian Business Cycle Theory was developed in the first quarter of the 20th century, mostly by Mises and Hayek, with some later contributions by Schumpeter. The data Mises and Hayek had to work on was that of that of the business cycle that emerged with industrial capitalism at the beginning of the 19th century and continued with varying amplitude throughout that century. In particular, it’s important to note that the business cycle they tried to explain predated both central banking in the modern sense of the term and the 20th century growth of the state. The case of the US is of particular interest since the business cycle coincided with a wide range of monetary and banking systems: from national bank to free banking, and including a gold standard, bimetallism and non-convertible paper money.

This NBER data goes back to 1857, but there was nothing new about the business cycle then (Marx, for example, had been writing about it for a decade or more). The US experienced serious “panics”, as they were then called in 1796-97, 1819 and 1837 [1] as well as milder fluctuations associated with the British crises of the 1820s and 1840s.

The typical crisis of the 19th century, like the current crisis, began with bank failures caused by the sudden burst of a speculative boom and then spread to the real economy, with the contraction phase typically lasting from one to five years. By contrast, recessions since 1945 have generally lasted less than a year, and have mostly been produced by real shocks or by contractionary monetary and fiscal policy.

According to the theory, the business cycle unfolds in the following way. The money supply expands either because of an inflow of gold, printing of fiat money or financial innovations that increase the ratio of the effective money supply to the monetary base. The result is lower interest rates. Low interest rates tend to stimulate borrowing from the banking system. This in turn leads to an unsustainable boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if price signals were not distorted. A correction or credit crunch occurs when credit creation cannot be sustained. Markets finally clear, causing resources to be reallocated back towards more efficient uses.

At the time it was put forward, the Mises-Hayek business cycle theory was actually a pretty big theoretical advance. The main competitors were the orthodox defenders of Says Law, who denied that a business cycle was possible (unemployment being attributed to unions or government-imposed minumum wages), and the Marxists who offered a model of catastrophic crisis driven by the declining rate of profit.

Both Marxism and classical economics were characterized by the assumption that money is neutral, a ‘veil’ over real transactions. On the classical theory, if the quantity of money suddenly doubled, with no change in the real productive capacity of the economy, prices and wages would rise rapidly. Once the price level had doubled the previous equilibrium would be restored. Says Law (every offer to supply a good service implies a demand to buy some other good or service) which is obviously true in a barter economy, was assumed to hold also for a money economy, and therefore to ensure that equilibrium involved full employment

The Austrians were the first to offer a good reason for the non-neutrality of money. Expansion of the money supply will lower (short-term) interest rates and therefore make investments more attractive.

There’s an obvious implication about the (sub)optimality of market outcomes here, though more obvious to a generation of economists for whom arguments about rational expectations are second nature than it was 100 years ago. If investors correctly anticipate that a decline in interest rates will be temporary, they won’t evaluate long-term investments on the basis of current rates. So, the Austrian story requires either a failure of rational expectations, or a capital market failure that means that individuals rationally choose to make ‘bad’ investments on the assumption that someone else will bear the cost. And if either of these conditions apply, there’s no reason to think that market outcomes will be optimal in general.

A closely related point is that, unless Say’s Law is violated, the Austrian model implies that consumption should be negatively correlated with investment over the business cycle, whereas in fact the opposite is true. To the extent that booms are driven by mistaken beliefs that investments have become more profitable, they are typically characterized by high, not low, consumption.

Finally, the Austrian theory didn’t say much about labour markets, but for most people, unemployment is what makes the business cycle such a problem. It was left to Keynes to produce a theory of how the non-neutrality of money could produce sustained unemployment.

The credit cycle idea can easily be combined with a Keynesian account of under-employment equilibrium, and even more easily with the Keynesian idea of ‘animal spirits’. This was done most prominently by Minsky, and the animsal spirits idea has recently revived by Akerlof and Shiller. I suspect that the macroeconomic model that emerges from the current crisis will have a recognisably Austrian flavour..

Unfortunately, having put taken the first steps in the direction of a serious theory of the business cycle, Hayek and Mises spent the rest of their lives running hard in the opposite direction. As Laidler observes, they took a nihilistic ‘liquidationist’ view in the Great Depression, a position that is not entailed by the theory, but reflects an a priori commitment to laissez-faire. The result was that Hayek lost support even from initial sympathisers like Dennis Robertson. And this mistake has hardened into dogma in the hands of their successors.

The modern Austrian school has tried to argue that the business cycle they describe is caused in some way by government policy, though the choice of policy varies from Austrian to Austrian - some blame paper money and want a gold standard, others blame central banks, some want a strict prohibition on fractional reserve banking while others favour a laissez-faire policy of free banking, where anyone who wants can print money and others still (Hayek for example) a system of competing currencies.

Rothbard (who seems to be the most popular exponent these days) blames central banking for the existence of the business cycle, which is somewhat problematic, since the business cycle predates central banking. In fact, central banking in its modern form was introduced in an attempt to stabilise the business cycle. The US Federal Reserve was only established in 1913, after Mises had published his analysis.

Rothbard gets around this by defining central banking to cover almost any kind of bank that has some sort of government endorsement, such as the (private) Bank of England in the 19th century, and arguing for a system of free banking that would avoid, he asserts, these problems. But, on any plausible definition of the term, the US had free banking from the Jackson Administration to the Civil War and that didn’t stop the business cycle (Rothbard offers some historical revisionism to argue that the Panic of 1837 didn’t really happen, but that wasn’t what US voters thought when they threw the Jacksonians out in 1840). And free banking in late 19th century Australia (our first quasi-central bank was the Commonwealth Bank established in 1915) didn’t prevent a huge boom and subsequent long depression around 1890. Overall, the US was much closer to free banking throughout the 19th century than in the period from 1945 until the development of the largely unregulated ’shadow banking’ system in the 1990s, but the business cycle was worse then (how much worse is a matter of some controversy, but no serious economist claims it was better).

To sum up, the version of the Austrian Business Cycle Theory originally developed by Hayek and Mises gives strong reasons to think that an unregulated financial system will be prone to booms and busts and that this will be true for a wide range of monetary systems, particularly including gold standard systems. But that is only part of what is needed for a complete account of the business cycle, and the theory can only be made coherent with a broadly Keynesian model of equilibrium unemployment. Trying to tie Austrian Business Cycle Theory to Austrian prejudices against government intervention has been a recipe for intellectual and policy disaster and theoretical stagnation."

looks upon the conditions of that mode of production as self-evident laws of Nature

TO BE NOTED: From Understanding Society:

"Primitive accumulation

Marx's treatment of the "so-called 'primitive accumulation'" is one of the most historically detailed sections in Capital: A Critique of Political Economy (Volume 1). And it is one of the most interesting parts of Capital to read as a separate piece. (Here is an electronic text of the section.) It is Marx's account of the historical processes of change in rural life of the fifteenth through eighteenth century in Britain and Ireland, through which peasants were forced off their land and the commons were enclosed. Marx believes that this separation of the peasantry from the land was a necessary condition for the development of capitalism, in that it created the conditions in which there was a pliable and abundant proletariat. This "free" proletariat was needed for the creation of the factory system and the development of manufacturing cities. So the process of primitive accumulation created the changes in social relations, property relations, and the accumulation of wealth that permitted the creation of the capital-labor relation and factory-based capitalism.

Marx sometimes puts this point in a fairly teleological way, looking at primitive accumulation as a necessary step on the road to British capitalism. (For example, he refers to this process as "the revolution that laid the foundation of the capitalist mode of production.") But it is possible, and preferable, to read Marx's analysis here less teleologically, as simply a detailed account of some of the crucial but contingent changes that took place in rural social relations during these centuries, without importing the idea that these changes were functionally related to the later development of capitalism. And read non-teleologically, the section holds up fairly well in relation to modern historical scholarship.

Marx describes the basic social relations of British rural life in the fifteenth century in these terms, as a freeholding peasantry with access to substantial common lands, pasture, and forest:

The immense majority of the population consisted then, and to a still larger extent, in the 15th century, of free peasant proprietors, whatever was the feudal title under which their right of property was hidden. In the larger seignorial domains, the old bailiff, himself a serf, was displaced by the free farmer. The wage-labourers of agriculture consisted partly of peasants, who utilised their leisure time by working on the large estates, partly of an independent special class of wage-labourers, relatively and absolutely few in numbers. The latter also were practically at the same time peasant farmers, since, besides their wages, they had allotted to them arable land to the extent of 4 or more acres, together with their cottages. Besides they, with the rest of the peasants, enjoyed the usufruct of the common land, which gave pasture to their cattle, furnished them with timber, fire-wood, turf, &c.

And he identifies the crucial turn towards expropriation of the free peasant proprietor:

In insolent conflict with king and parliament, the great feudal lords created an incomparably larger proletariat by the forcible driving of the peasantry from the land, to which the latter had the same feudal right as the lord himself, and by the usurpation of the common lands. The rapid rise of the Flemish wool manufactures, and the corresponding rise in the price of wool in England, gave the direct impulse to these evictions. The old nobility had been devoured by the great feudal wars. The new nobility was the child of its time, for which money was the power of all powers. Transformation of arable land into sheep-walks was, therefore, its cry.

(It is interesting to recall that Oliver Goldsmith describes the eighteenth-century version of this process in Ireland in his poem, The Deserted Village (1770):

Sweet smiling village, loveliest of the lawn,
Thy sports are fled, and all thy charms withdrawn;
Amidst thy bowers the tyrant's hand is seen,
And Desolation saddens all thy green:
One only master grasps the whole domain,
And half a tillage stints thy smiling plain.
No more thy glassy brook reflects the day,
But, choked with sedges, works its weedy way;
Along thy glades, a solitary guest,
The hollow-sounding bittern guards its nest;
Amidst thy desert walks the lapwing flies,
And tires their echoes with unvaried cries:
Sunk are thy bowers in shapeless ruin all,
And the long grass o'ertops the mouldering wall
And, trembling, shrinking from the spoiler's hand,
Far, far away thy children leave the land.

Ill fares the land, to hastening ills a prey,
Where wealth accumulates, and men decay.
Princes and lords may flourish, or may fade;
A breath can make them, as a breath has made:
But a bold peasantry, their country's pride,
When once destroy'd, can never be supplied. )

And Marx emphasizes the coercive nature of this expropriation of the yeoman peasant:

Even in the last decade of the 17th century, the yeomanry, the class of independent peasants, were more numerous than the class of farmers. They had formed the backbone of Cromwell’s strength, and, even according to the confession of Macaulay, stood in favourable contrast to the drunken squires and to their servants, the country clergy, who had to marry their masters’ cast-off mistresses. About 1750, the yeomanry had disappeared, and so had, in the last decade of the 18th century, the last trace of the common land of the agricultural labourer. We leave on one side here the purely economic causes of the agricultural revolution. We deal only with the forcible means employed.

A crucial component of the "primitive accumulation", in Marx's interpretation, was the abolition of common property, culminating in the enclosure acts in the seventeenth century:

Communal property — always distinct from the State property just dealt with — was an old Teutonic institution which lived on under cover of feudalism. We have seen how the forcible usurpation of this, generally accompanied by the turning of arable into pasture land, begins at the end of the 15th and extends into the 16th century. But, at that time, the process was carried on by means of individual acts of violence against which legislation, for a hundred and fifty years, fought in vain. The advance made by the 18th century shows itself in this, that the law itself becomes now the instrument of the theft of the people’s land, although the large farmers make use of their little independent methods as well. The parliamentary form of the robbery is that of Acts for enclosures of Commons, in other words, decrees by which the landlords grant themselves the people’s land as private property, decrees of expropriation of the people. Sir F. M. Eden refutes his own crafty special pleading, in which he tries to represent communal property as the private property of the great landlords who have taken the place of the feudal lords, when he, himself, demands a “general Act of Parliament for the enclosure of Commons” (admitting thereby that a parliamentary coup d’état is necessary for its transformation into private property), and moreover calls on the legislature for the indemnification for the expropriated poor.

We even are afforded a glimpse of the economist's view of the rationality of enclosure. According to John Arbuthnot, enclosure and the creation of private farms is a more productive use of land and labor:

Let us hear for a moment a defender of enclosures and an opponent of Dr. Price. “Not is it a consequence that there must be depopulation, because men are not seen wasting their labour in the open field.... If, by converting the little farmers into a body of men who must work for others, more labour is produced, it is an advantage which the nation” (to which, of course, the “converted” ones do not belong) “should wish for ... the produce being greater when their joint labours are employed on one farm, there will be a surplus for manufactures, and by this means manufactures, one of the mines of the nation, will increase, in proportion to the quantity of corn produced.”

And here Marx describes the final stages of the "rationalization" of agriculture, in the expropriation of the Scots:

The last process of wholesale expropriation of the agricultural population from the soil is, finally, the so-called clearing of estates, i.e., the sweeping men off them. All the English methods hitherto considered culminated in “clearing.” As we saw in the picture of modern conditions given in a former chapter, where there are no more independent peasants to get rid of, the “clearing” of cottages begins; so that the agricultural labourers do not find on the soil cultivated by them even the spot necessary for their own housing. But what “clearing of estates” really and properly signifies, we learn only in the promised land of modern romance, the Highlands of Scotland. There the process is distinguished by its systematic character, by the magnitude of the scale on which it is carried out at one blow (in Ireland landlords have gone to the length of sweeping away several villages at once; in Scotland areas as large as German principalities are dealt with), finally by the peculiar form of property, under which the embezzled lands were held.

Eventually we come to the point where industrial capitalism is feasible and there is a "free" proletariat available for labor:

It is not enough that the conditions of labour are concentrated in a mass, in the shape of capital, at the one pole of society, while at the other are grouped masses of men, who have nothing to sell but their labour-power. Neither is it enough that they are compelled to sell it voluntarily. The advance of capitalist production develops a working-class, which by education, tradition, habit, looks upon the conditions of that mode of production as self-evident laws of Nature. The organisation of the capitalist process of production, once fully developed, breaks down all resistance.

And, of course, Engels picks up the story from the perspective of nineteenth-century Manchester and Birmingham, and the conditions of squalor and oppressive factory labor that resulted. (See an earlier posting on Engels's sociology of the proletarian city.)

The English Marxist historians have devoted a lot of their attention to this period of British social history. (Harvey Kaye gives a very good account of the work of this generation of Marxist historians in The British Marxist Historians.) Maurice Dobb is one of the English socialist historians who has retraced Marx's steps on this subject in some detail. One of Dobb's important books, Studies In The Development Of Capitalism (1963), treats this process of the decline of the English peasantry and the rise of the proletariat, making use of the historical scholarship of the first part of the twentieth century. Some of Rodney Hilton's research on this period can be found in Class Conflict and the Crisis of Feudalism: Essays in Medieval Social History (Rev). Several generations later, Robert Brenner gave a somewhat different interpretation of the history of agrarian change in England from the sixteenth to the eighteenth centuries; his views were developed in the splendid journal Past & Present and were separately published along with a round of critical reactions in The Brenner Debate: Agrarian Class Structure and Economic Development in Pre-industrial Europe.

Posted by Daniel Little at 8:28 PM